Why do investors tend to move in herds, buying when others buy and selling when others sell? According to a new study, it’s because of biology.
The study, detailed by The Wall Street Journal’s Jason Zweig in his latest column, was performed by researchers from University College London and Denmark’s Aarhus University and published in Current Biology. In it, participants were asked to list songs that they most wanted to buy online. They were then given ratings of those songs by two professional music “experts”, as their brainwaves were being monitored. Then they were asked if they wanted to alter their list of songs they wished to purchase.
The findings: “The brain scans showed that as soon as people learned they had chosen the same song as the experts, cells in the ventral striatum — a reward center wired with dopamine neurons that respond to pleasures like sugar and sex — fired intensely,” Zweig says. In addition, the scans showed that finding out that experts agree with each other (regardless of whether the participants agreed) triggers activity in the participant’s insula, which Zweig notes is a part of the brain associated with pain and heightened body awareness. “This suggests that the agreement of others may have a special ability to grab our mental attention,” he says. “No wonder a consensus opinion is almost impossible for many investors to ignore.”
All of this shows that investors don’t just move in herds because of a “safety-in-numbers” phenomenon, Zweig says. It also gives them pleasure on a biological level. “That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the ‘consensus view’ on Wall Street,” Zweig says.
Of course, following the herd can be a great way to buy overpriced stocks. Zweig’s advice to stock-pickers: Start with stocks that are making new 52-week lows to avoid the herd mentality. Then examine a firm’s financial statements, products and competitors to asses the value of its business “while ignoring the current price of its stock”. And, he says, you should “make a permanent record that thoroughly details your rationale for making the investment. That way, you set in stone exactly where you stood before the herd began trying to sweep you away.”