Wednesday, 22 December 2010

Does crowd mentality influence your investment?

The BSE Sensex has multiplied six-seven times over the last decade. And many stocks have sky-rocketed. Some investors have made money. Others have lost money. And most people continue to lose. Strikingly, most people also do what most other people do. Isn't that quite a coincidence? 

In our previous article on crowd mentality, we had emphasised the need to keep away from crowds and to stay focused on company fundamentals. Now let us understand some dynamics of this phenomenon called 'crowd'. We have all had our share of experiences at 'becoming a crowd'. Let's recount some. 

Situation/ ActivityOur response in a crowd
Watching a cricket match in a jam packed stadiumWe end up yelling and cheering more than we would
otherwise if watching alone on TV. 
In a professional company meetingWe're prone to agreeing more often than not.
In Bombay local trainsNeed we say anything?
The 2007 bull run. The 2008 crashRemember???

Let's look back at these common experiences with a different perspective. Of all, one thing is quite clear: 

Being part of a crowd causes people to behave differently from the way that they would in isolation. 

Crowds introduce a very overwhelming emotional and often irrational element to decision-making: making an individual equate his own needs with those of the crowd. This is particularly noticeable in financial markets. At peaks and troughs of the stock market, for example, very few people will be concentrating on the fundamental economic influences. The vast majority will be concerned with only the recent short-term movements in prices themselves. Consequently, this majority will inevitably be on the wrong foot when a price reversal occurs. 

People who have spent a decent amount of time investing in stocks must have often felt a two-way pull on their decisions. Their 'personal' approach may suggest one course of action. On the other hand, the lure of the 'herd instinct' may be pulling entirely in the opposite direction. This is true even for a lot of seasoned professionals. The reason for this two-way pull lies in these two primary tendencies- 

Self-assertive tendency: the ability to behave in a self-determined way. 

Integrative tendency: the willingness to belong to crowds. 

What we ultimately do depends on which of these two tendencies stands prominently in us. 

A crowd is something other than the sum of its parts 

A crowd is a psychological phenomenon. Its formation does not really require the physical presence of its members. All that is needed is a common cause. The most striking peculiarity of a crowd in a financial market is this: 

The individuals composing a crowd may be very different from each other. They may differ in their lifestyles, their character, or their intelligence. But the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind. And the way they feel, think and act gets altered drastically. 

Doesn't this remind you of chemistry lessons? Two or more different elements combining together. Then transforming into a compound whose characteristics are quite distinct from that of its components. Ditto for investors! Successful investment, therefore, depends on an individual's ability to stand aside from the crowd's influence.


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