Herd mentality bias—2-minute video

Is the herd mentality bias affecting your clients? Help them find out by sharing this short, client-approved video, which provides actionable insights and guidance on how the herd mentality bias can potentially influence our investment decisions. Then consider exploring the behavioral finance program for advisors linked near the bottom of the page for follow-up tools.

Herd mentality bias in perspective

It's easy to stick with what's familiar—but doing so can harm client portfolios.

Key Takeaways:

• Herd mentality bias leads people to make choices based on what they see other people doing due to fear or missing out, or FOMO.
• This bias may cause investors to take unnecessary risks and to skip vital steps, such as due diligence, research into an asset’s fundamentals, and disciplined portfolio constructions.
• Herd mentality may also lead investors to make hasty decisions based solely on the latest market trends or prevailing sentiment.
• Investors with this bias often buy high and sell low, ignoring their long-term investment objectives and dampening their portfolio’s performance.
• In aggregate, herd behavior can generate market bubbles and fuel panic selling. Advisors can potentially help clients manage this bias by clearly conveying the potential risks associated with currently popular investment trends.
• Thoughtfully emphasizing the benefits of a systematic approach to rebalancing and sticking with an agreed upon asset-allocation approach is another tactic that may help clients over the long term.

What is herd mentality bias?

Herd mentality bias—which is also known as momentum investing—is the tendency to copy the behavior of others instead of making independent decisions. A study by researchers at the University of Leeds found that when just 5% of a crowd seems to know where it is going, the other 95% of people will follow along without realizing they are copying the informed group.¹

As social creatures, people are hard-wired to go along with others. The assumption is that if a group is behaving a certain way, its members may know something that we don’t. For example, a long line at the local bakery suggests that it must have great pastries.

In investing, herd mentality may lead people to invest in certain stocks or strategies simply because of their popularity, an approach that may also lead to panic selling when the markets are tumbling. Some investors may also feel like they need to conform with their peers, taking comfort in the idea that there’s safety in numbers.

At a glance: Herd mentality bias

Herd mentality is a cognitive bias. It describes the tendency to copy the behavior of others, rather than acting independently.

Herd mentality bias is often a root cause of market bubbles. The dot-com bubble of the late 1990s and early 2000s occurred as media and investors paid increasing attention to the soaring valuations of internet companies.

Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results. For more information on indexes, please see: https://www.schwab.com/resource/index-andinvestment-term-definitions.

The problem: 
It’s effectively impossible to time the market or individual stocks. Investors following the herd can’t know whether it will keep running or stampede off a cliff.

Take investors who bought Amazon stock after it gained nearly 1,000% in 1998. They looked brilliant in 1999, gaining 42%. But if they stuck with the herd and bought more Amazon stock at the end of 1999, their new investment would have dropped 80% over the next 12 months.

Amazon annual returns during the dot-com bubble***

For illustrative purposes only. Past performance is no guarantee of future results..

How advisors can help: Help clients understand the reasons for diversification, create guidelines around trading, and suggest a media diet.

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* St. Louis Fed (FRED). https://fred.stlouisfed.org/series/NASDAQCOM

** Market Watch: https://www.marketwatch.com/investing/index/spx/download-data

*** Sources: Schwab Asset Management; Bloomberg. Data calculated as of 10/31/24.

Why does it matter?

Herd mentality bias plays into the human instinct to conform or blend in with the rest of the crowd. Yet doing so can cause investors to ignore the fundamental and technical underpinnings of an asset’s relative worth in favor of a groupthink approach.

This behavior can damage portfolio performance in the long term as investors can potentially act on flawed thinking, rather than following a disciplined long-term strategy. By taking the easier route of going with the flow, investors may skip their due diligence, research, and analysis that are vital elements of successful portfolio management.

Herd mentality bias may also cause investors to buy high and sell low. Panic buying and selling are common when investors see that other people are jumping on an asset or rushing to get out of it. For example, the S&P 500® Index dropped by more than 30% in early 2020, as investors panicked at the beginning of the COVID-19 pandemic. Many investors suffered losses by selling at those lows, rather than holding onto securities and ultimately benefiting as the market subsequently rebounded.

What can you do about it?

The first step in helping clients avoid herd mentality bias is communicating openly about the potential risks associated with this approach. Provide clients with examples and historical trends that demonstrate how this bias has played out in the past. Show them how independent, informed decision-making creates value over time and ask whether they are feeling pressured to make certain decisions. For clients who seem to be suffering from the effects of the herd mentality bias, a financial media news diet or avoidance during sharp market movements may make sense.

You can offer another antidote to herd mentality by helping clients understand the rationale behind the construction of their portfolio, including that it is built to withstand a variety of market conditions and fads. Establishing objective trading rules that trigger the buying, selling, and rebalancing of holdings when certain objective measurements are reached is another mitigation strategy that might help. For example, your client might decide to only buy or sell assets when the market rises or falls by a certain percentage.

Making clients aware of herd mentality bias and showing them how they can manage the potential risks associated with this bias does more than potentially improve portfolio outcomes. These conversations can help strengthen the relationships you have with clients and reinforce the trust they have in your counsel.

Omar Aguilar, Ph.D.
President, Chief Executive Officer, and Chief Investment Officer