Herd mentality makes investors react irrationally

An investor, specially the retail investors are often puzzled by the way stock markets both globally and in India react to news, the most recent being Brexit. Markets just collapsed like a house of cards; going into a tailspin, though they did recover some of their losses during the day.

Markets move on sentiment and so often act irrationally. They are also fickle as the next day they could be up and kicking, what market men all taking advantage of the ‘buying opportunity’. But that is the nature of the beast, as they say.

Market psychology is an often talked about subject yet it is difficult to comprehend how market will react in a particular situation. There are too many moving parts for a given situation and each of those are converted as information for consumption by the investors. These investors react to information flow whether rumours, views or events.

A collective reaction of investors is the volatility that we see in the markets. The volatility in the markets has increased in the recent past as the speed of information flow has multiplied manifold.

There are basically two types of events: 1. An expected event of which the outcome is unknown 2. An unexpected event.

It’s natural for high volatility on occurrence of an unexpected event basically because the market participants were not prepared for it. 9/11 is an apt example of an unexpected event.

Prior to the expected events, market participants tend to follow popular view that majority of the participants hold. This is based on the belief that if so many people or a group of “influential knowledge leaders” have a certain opinion regarding a situation, then it is assumed that they possibly know something that ordinary investors don’t and it is unlikely that such a large group could go wrong. This leads to a situation known as ‘herd behaviour’ where the rest follow blindly without knowing where one is headed but continues to feel safe till the event proves them otherwise.

We see enhanced volatility during key national or global events. Investors seem to be overwhelmed during the currency of such events but when we look back, most of them seem trivial from the point of view of providing long term direction to the markets. However, there are very few global events which result in being game changers.

Coming to the recent event of Brexit, the market was flooded with a popular opinion that UK would remain in the EU. The global markets rallied as the risk seemed very low. The pound sterling too soared the day before on the “remain” hype. So when ‘Brexit’ reality dawned, the ‘herd’ was caught unaware and what we saw on Friday morning was a reaction of the majo-rity participants who were caught on the wrong foot. This could be a game changer for Britain but the effect for India could be negligible in the long run.

Then why do we react to such news The answer lies in the fact that India is not “decoupled” with world markets which are seamlessly connected, the global mood is bound to affect the domestic bourse.

Increased volatility also leads to sharp emotional mood swings among traders and investors moving from exuberance or jubilation to fear and pain. This leads to making irrational decisions which lead to losses. Exuberance leads to high self-confidence whereas fear leads to self doubt. Both these situations are disastrous for investment portfolio.

A winning investor or a trader in a market is one who not only has a deeper understanding of his positions but also has control over his emotions and is not swayed by the noise around. I strongly believe that market is the game of strength of mind supported by knowledge and not vice versa.

(The writer is a senior market analyst)