Key Points:
- The herd bias phenomenon, or “the bandwagon effect,” leads individuals to make investment decisions based on the belief that “everyone’s doing it.”
- Experienced investors are also prone to illusory superiority bias, which causes overconfidence in their decision-making abilities and a belief that their decisions are both superior and unique.
- First-principles thinking and basing decisions on internal findings and data can help mitigate bias in investment decisions.
- It is important to stay focused on internally specified outcomes and ignore popular investment strategies or assumptions of what makes an ideal investor.
- By staying disciplined, independent, and objective, investors can avoid impulsive behaviors and identify profitable contrarian positions.
Most long-time investors are familiar with the phenomenon known as herd bias, or “the bandwagon effect.” It is a behavior that leads individuals to make investment decisions based on the belief that “everyone’s doing it.” This type of behavior is often associated with novice retail investors who lack confidence in their own decision-making abilities and resort to panic-buying or selling. However, this bias is not limited to retail investors and can also affect seasoned investors.
For example, recent surges in the price of GameStop shares and the dogecoin cryptocurrency have been attributed to the herd mentality. Many veteran traders and institutional investors were part of the stampede, some making money and others getting burned. This raises the question of why experienced investors would join the herd.
Experienced investors are prone to a different type of bias called illusory superiority bias. This bias is characterized by overconfidence in one’s decision-making abilities and the belief that their decisions are both superior and unique. It often leads to an incorrect interpretation of facts and an incorrect decision. It can even cause investors to consciously or unconsciously ignore facts that don’t align with their thesis.
Illusory superiority bias is not limited to accredited investors in stocks and cryptocurrencies. Venture capital and private equity firms with successful track records can also fall victim to this bias, leading to unprofitable positions. It is a bias that can be found in almost every aspect of life and is closely related to the Dunning-Kruger effect, which causes individuals to overestimate their abilities.
To guard against bias in investment decisions, it is important to stick to first-principles thinking. This involves basing each decision on internally developed findings and data. The cautionary tale of Theranos, a blood testing company that raised hundreds of millions of dollars before its technology was proven, highlights the importance of relying on facts rather than assumptions.
Staying cognizant of the investment thesis, keeping target criteria in mind, and detecting outside influence are key strategies for avoiding bias. This may involve rejecting assumptions of what makes an ideal investor and ignoring popular investment strategies. Instead, the focus should be on internally specified outcomes.
By engineering the forces we can control while observing those we can’t, investors can avoid impulsive behaviors such as panic buying and selling. Taking a disciplined and objective approach can lead to smarter investment decisions and help identify profitable contrarian positions. This ultimately reduces the likelihood of joining the herd and increases the chances of success.
In conclusion, both herd bias and illusory superiority bias can affect experienced investors. To mitigate these biases, it is important to rely on internal findings and data, stay focused on internally specified outcomes, and reject popular investment strategies or assumptions. By taking a disciplined and objective approach, investors can make smarter decisions and avoid the pitfalls of herd mentality and overconfidence.
