Herd Behavior and Perception Biases


You're Something of a Phenomenon

Very few people ever think about things like this but to me the behavior of Bee Hives or Ant Colonies is an extraordinary phenomenon.  I know this sounds like a weird concept and you may think that you shouldn't waste your time thinking about it, but a rudimentary understanding of it will help your investments.  In a Hive or a Colony there are literally millions of individuals minds or individuals thinking or acting upon their own individual thoughts or instincts without regard or consideration of what the Hive or Colony is doing.  Yet somehow by these millions of separate individualistic actions the colony is capable of making group decisions.  An ant or a bee just does what it does and I assume they really don’t think too deeply.  I’ve yet to see a bee or ant read Shakespeare or play chess.  (Of course, stupid humans generally don't play chess or read Shakespeare either)

For example, Army Ant Colonies in the Brazilian Rain Forest somehow know that they need to move before the floods come and they successfully take journeys of miles. I highly doubt that the Queen Ant is sending out emails or Tweets telling the Colony what to do.  Somehow the Queen understands that it is time to move and as far as we know, She communicates with the Ants that are immediately next to her and they communicate with the Ants that are immediately next to them and so on and so and so on.  And yet somehow the Colony as an aggregate Group behaves like an individual and knows that it is time to move and it (or they) know just exactly what to do and when to do it.
The important thing to understand is that the individual Bees or Ants have what could be understood as two motivations when they pretty much do anything or take any action.  On the one hand the individuals think they are acting upon their own wishes and desires and motivations and they are.  But not only are they thinking and acting for themselves.  They are also responding to the stimuli and influences that they receive because they have a relationship with and are a member of a crowd or a group.  These external stimuli influence their decisions even though they may not be consciously aware of it.  A crowd is larger than the sum of its parts and each individual’s behavior is altered when they become a member of a crowd.

 The Psychology of the Human Crowd

You may not know it but this behavior also occurs in humans as well.  We may think that we are thinking for ourselves and that we are independent.  But in fact we are thinking for ourselves but at the same time we are also thinking for the group as well...just like a bee or an ant does.  We are not islands.  Thoughts and actions are not absolute or isolated...they are in fact a response to external stimuli and need to be considered as a reactionary dynamic.  Psychologists used to think that our decisions were basically mechanical and individualistic but now they realize that most of the time we are making decisions because we are also responding to eternal stimuli and our decisions are essentially a result of our relationship with our environment.  We need to understand that our actions thoughts are kind of a two-way street.  You may think that your thoughts are your own but they are influenced heavily and maybe even determined by relations to the environment. 

Why does this happen?  Because we as human beings are animals and the part of our brains that cause us to have rational thought has only recently evolved.  The part that makes us animalistic has been there much longer.  Back in the old days, and those old days consist of hundreds of thousands if not millions of years, the Flight or Fright response worked.  If you were scared because you were about to become the afternoon snack of a Saber Tooth Tiger, adrenalin was a good thing.  Your instincts would kick in and you singular focus would be to fight or flight and get out. 
But when you are scared in the markets its a bad thing.  We can lose control because our instincts can become more powerful than our ability to be self-aware.  The markets have only existed for a few centuries which is just a blink in time compared to how long our animal instincts have been developing.   Instinct wants to make you run with the pack because this reduces your chance of being the prey.  But if you can remember that the market isn't a Saber Tooth Tiger and you can use logic to make decisions when the rest of the herd is fleeing you can find successful trades.  

The Proof of this is Everywhere

The proof of this everywhere. I used to witness strange behavior every day in our fellow humans at Grand Central Station when I worked in NYC.  Every day you see people crowding into the first car of the train.  As more passengers walk by and see this they too crowd into the first car until all of the seats are full.  People get angry and complain to the Conductor because they can't find a seat.  But if they only went around this crowd and headed towards the front of the train they would realize that the cars in the front are empty.  There are literally dozens of empty seats and everyone can sit comfortably.  This is a prime example of group or herd behavior in action that you can literally witness every day. 

Think of how this dynamic also plays out in fashion.  You may disagree over whether a tie is nice or ugly, but you have still accepted the fact that ties in general look nice.  That is because you are part of a group and you have somehow come to accept that this is the right or correct way of fashion.  But think of how ridiculous we think fashions in other cultures or in the past are.  Those guys wearing pantaloons back during Shakespeare’s day thought they looked as cool as the Hipsters do now with their skinny jeans.  (FYI-they both look stupid...)

This herd phenomenon is also obvious in other areas or our culture as well.  Think about sports.  People who don’t know each other can form an immediate relationship and have an acceptance of others just because they are wearing the shirt of a specific team.  This is a powerful example of how strong the herd or crowd mentality still is in modern humans.  There are literally countless example of people being hurt or even killed because they happened to be rooting for the wrong team at the wrong place.  Had these people and the people that harmed them met under different circumstances wearing different clothes they may have become the best of friends.   Obviously, the same behavior is easily recognized in the crowd dynamics associated with politics, religion, music and so on…

We have individualistic motivations but we also have group, crowd, or herd motivations as well and sometimes they are even more powerful.  What happens when we become a member of a crowd?  Instincts, emotions and biological drives cause people to act differently as members of the crowd than they do as individuals.  We need to understand that when this happens sometimes we lose our ability to reason and think logically because it causes the suppression of selfawareness and emotions to overcome reason.

In the market participants are members of a crowd because they have a common objective and that is to make profits.  When you enter a position, you become a member of this crowd.  This dynamic ensures that by definition stock market behavior is a crowd phenomenon.  People tend to identify themselves with their positions and this is a dynamic that drives bubbles or crashes.  In a bubble people are members of the crowd who have made profit so they can all relate to the same stimuli.  It's the same thing with crashes and fear – at least if you are wrong you did what everyone else did so you don’t have to feel stupid.  The leader of this crowd is literally the market itself...as personified by the numerical levels of stock indices or stocks as reported on the news.

If you realize and have a self-awareness that you are a member of the herd, it will be much easier to separate yourself from it and utilize logic instead of emotions to make decisions.  And not only will this benefit your trading and investing, it will benefit other areas of your life as well.  

Perception Biases

Perception Biases are caused by our emotional makeup and make us act in ways that prevent us from making decisions that allow economic utility maximization.  In other words, they cause us to do stupid things that defy logic.  
Some psychologists believe that we evolved these emotions and ways of thinking because somehow, they help us in an evolutionary way.  Well…maybe this is true if you are being stalked by a man-eating lion in the wilderness but they certainly don’t help with investing. 

I’m not a psychologist and maybe I have some of the details wrong here but the important thing is to be aware that as humans we are all perceptible to them.  You…me…Aunt Mary…everyone.  When you make a trading or investment decision you should ask yourself why you are doing it to make sure that the motivation isn’t purely emotional.  This is a good reason to have and use a journal.  By forcing yourself to write out the reasons why you are doing something it may make you realize that you are making a trade due to emotions and that usually isn’t good.

Here are some Perception Biases that are common to investing and trading.  There is overlap between them but don’t be too worried about knowing the precise nuances of each.  Just realize that they can make you lose a lot of money.
Confirmation Bias - This is the tendency to see, interpret or remember things in a way that confirm a belief or hypothesis that we hold.  This causes us to ignore or undervalue evidence that may be contrary to our opinion.  For example, if we have an opinion on a particular position we tend to ignore or not give enough credence to information that may refute those opinions.  You may be bullish on a particular stock and this may lead you to ignore or discredit an analyst who is making a compelling bearish argument on the stock, while giving too much credence to an analyst who is bullish on the stock but making a very weak argument in favor of it.  This is an easy bias to succumb to.  When I trade I try to avoid it by shutting off the TV and ignoring the media and the Wall Street ‘Gurus”.  That way I can develop an unbiased opinion.6
Bandwagon Bias - This bias is probably a manifestation of our innate tribal or herd instincts.  This is the phenomenon that the more people believe in or do something then the more others will want to believe or do the same.  Think of the phrase ‘spiraling out of control’.  I suppose from an evolutionary perspective this bias makes plenty of sense because there is strength in numbers and animals that hunt in packs are more successful than animals that hunt alone. 
The way you can really see this is with the illogic of sports and sports fans.  They may not even know someone but because another random person is wearing the shirt of their favorite team somehow, they have a special bond.  This bias also explains fashion trends.  Why do fashions become popular and why are they so important?  We laugh and think that people dressed like fools in the past if we see pictures from Shakespearian or Victorian days.  Well…think about today.  What about a tie?  In the future people are going to laugh and talk about how stupid we are for wearing and thinking that ties look good.  You think your tie or your dress or your hat or whatever looks good because you have the bandwagon bias.
Obviously, this is a bias than can negatively affect trading because although you want to be on the bandwagon and a member of the pack while things are trending up or down, you don’t want to be on the bandwagon when trends are about to turn.  
Gambler's Fallacy - This is when we put too much emphasis on recent events and think that they will somehow influence future events.  It is the mistaken belief that if something happens more frequently than expected then it will happen less frequently in the future.  The classic example is flipping a coin.  Suppose I flip a coin and I get ‘heads’ ten times in a row.  What are the odds of the next flip being heads?  Most people would feel that a ‘tails’ is due.  They would then assume that in the next flip I would get ‘tails’ despite the fact that it is still exactly a 50% chance.
Positive Expectation Bias - Casinos and the gambling industry wouldn’t exist if people weren’t susceptible to this bias. This is when we feel our luck is due to change despite the fact that statistics and probabilities don’t bear this out.  Think of the person who plays slot machines. They keep pouring in money because they believe their luck is due to change. Yet the slot machine is a computer. It can’t lose.  

In trading and investing this could lead us to hold on to our losers and average down. They say that the definition of insanity is doing the same thing over and over and expecting a different result.  Maybe its true insanity and maybe it isn’t.  But it seems pretty obvious to me that this is caused by the fact that people have this bias.  They expect things to be different despite the contrary and opposing evidence.
Saliency Bias - This bias comes from thinking too short-term.  We use the most notable or most obvious traits to make a judgment about a situation while forgetting things that have happened in the past.  If we haven’t encountered something recently we tend to ignore or down play its probabilities.  This leads to the ability to think “this time it’s different”.  That’s why in Bubbles or Crashes people forget that the market will eventually go down or rise.  They get too focused on the short-term and forget that history repeats itself.  If you are aware of this bias in others you can make a fortune in the next Bubble.  And yes…there will be more bubbles as long as there are markets and there are humans investing in the markets because humans possess this bias. 
Projection Bias - This is the bias of thinking that other people think in the same way that we do.  You just kind of assume that everyone else views life in the same way that you do.  That is why sleazy people don’t mind taking advantage of or cheating others.  It is because they believe that the other person is equally capable of doing the same thing to them.  Similarly, people who are good are likely to be taken advantage of because they assume that other people are good like they are.  I’m not so sure how this directly applies to investing, but it’s a great life lesson so I included it.   
Anchoring Effect - This is when you need to make a guess but only have limited information. There is a tendency to rely too heavily on the first piece of information that is received when individuals use an initial piece of information to make subsequent judgements. The first number ‘anchors’ your opinion.  A classic example is the way menus are laid-out in highly priced restaurants. The first entrée is typically very high priced and after you see this it makes the other items seem like a bargain.  Wise restaurant owners make the second highest price item have the best profit margins because they know that their customers are most likely to order it. 
Another example is how in a store when someone sees an item that is on sale they focus on the amount of money that is (allegedly) saved as opposed to the initial value which could be highly overinflated.  An item may seem like a bargain at 30% off.  But what if the day before the price went from $50 to $100?  Paying $70 is better than paying $100…but it is still more than $50.
In investing or trading this could lead us to think a stock is worth buying just because it is down, or it is at a nice round number.  For example, think of how appealing the idea of buying a stock at $5 a share if just a month prior it was at $10.  The reality is that it could go to zero.
Summary and Conclusion

We have individualistic motivations but we also have group, crowd, or herd motivations as well and sometimes they are even more powerful. 

If you realize and have a self-awareness that you are a member of the herd, it will be much easier to separate yourself from it and utilize logic instead of emotions to make decisions.  And not only will this benefit your trading and investing, it will benefit other areas of your life as well.