Why we follow the crowd even when we know it's wrong
Psychologist Solomon Asch demonstrated in a series of 1951 experiments just how far social pressure can distort individual judgment. He asked a group of people (all but one actually actors planted for the experiment) to compare the length of some lines and give an obviously incorrect answer out loud, publicly. Around 75% of the real subjects conformed to the group's incorrect answer at least once, even though the correct answer was, at a glance, obvious.
In financial markets, this instinct combines with an additional mechanism called an 'information cascade': if you see a lot of people buying an asset, it's rational to assume, at least in part, that those people might have information you don't, even though in reality each of them may simply be copying everyone else in the same cascade, with no one actually holding any new information at all.
A recent example: the 2021 GameStop frenzy
in late January 2021, shares of GameStop, a video game retail chain in structural decline, went from trading around $20 to topping $480 within days, driven by a massive coordinated effort by individual investors on the Reddit forum r/WallStreetBets. Many buyers weren't analyzing the business's fundamentals: they were buying explicitly because they saw the price rising and thousands of other people buying at the same time.
The outcome followed the same pattern as the bubbles we already covered in our guide on historical speculative bubbles, from tulip mania to the dot-com crash: the stock collapsed as fast as it had risen, leaving later buyers with severe losses, while some of the earliest participants had already sold for multi-million-dollar gains.
The proof that this bias really costs money: the DALBAR studies
Financial research firm DALBAR has published an annual study for more than two decades ('Quantitative Analysis of Investor Behavior') comparing the returns individual investors actually earn in equity funds against the return of the market index they're invested in. The result repeats year after year: the average investor systematically earns a return several percentage points lower than the market, not because of picking bad funds, but because of bad timing getting in and out of them.
DALBAR's explanation matches the herd behavior pattern: money inflows into investment funds spike after periods of strong gains (when collective enthusiasm pushes people to buy in) and outflows spike after sharp declines (when collective panic pushes people to sell), exactly the opposite of buying low and selling high.
- Money floods into funds after they've already risen a lot.
- Money floods out of funds after they've already fallen a lot.
- The result: the average investor systematically buys higher and sells lower than the fund itself.
Why it's so hard to go against the crowd
Going against the current when everyone around you (friends, social media, news headlines) seems to be making money on a specific trend takes considerable psychological resilience, similar to what it takes to hold a diversified position while a trendy asset soars without you. It's exactly what the few contrarian investors in this series did, like Michael Burry, who withstood nearly two years of pressure from his own investors for betting against market consensus before the facts proved him right.
Most people have neither Burry's information nor his psychological resilience, and that's precisely why herd behavior keeps working so reliably, generation after generation, despite its consequences being well known.
How to protect yourself from herd behavior without being a contrarian genius
You don't need to become a contrarian investor to protect yourself from this bias: automating your investment strategy (fixed periodic contributions, regardless of whether the market is up or down that month) is enough to remove the emotional decision of 'when' to get in or out, which is precisely where herd behavior does the most damage.
Systematically distrusting any asset presented as 'the opportunity you can't miss' precisely when the most people are talking about it, and remembering that by the time a trend is making headlines everywhere, most of the gain has probably already happened, are two simple habits that prevent much of the damage this bias tends to cause.
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Frequently Asked Questions
It's the tendency to copy the decisions of a large group of investors instead of relying on your own analysis, even when the available evidence suggests that collective decision could be wrong.
DALBAR's annual studies consistently show that the average individual investor earns a return several percentage points lower than the very market they're invested in, mainly because of bad timing buying and selling.
A massive group of individual investors coordinated on the Reddit forum r/WallStreetBets drove its price up more than 1,700% in a matter of weeks, before it collapsed just as quickly, following the classic pattern of a speculative bubble.
It's the mechanism by which people assume that, if a lot of people are buying an asset, those people must have information they don't, when in reality each of them may simply be copying everyone else with no real new information behind it.
By automating your periodic contributions to remove the decision of 'when' to enter or exit the market, and by distrusting any asset presented as an urgent opportunity precisely when the most people are talking about it.