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Herd and False Superiority Bias

05 Jan 2023

Recent increases in the price of GameStop stock and the cryptocurrency dogecoin, among others, appear to defy basic examination and are therefore frequently linked to herd behavior. The dot-com bubble at the turn of the millennium can be compared to this. Pundits frequently interpret unexpected drops in the value of overbought assets as proof that the conventional wisdom that the herd is always wrong is true.

But not all buyers of these assets were driven by traders in the situations of GameStop and dogecoin. The stampede included seasoned traders and institutional investors. Some of them lost money, while others prospered. With their sophisticated algorithms and extensive financial knowledge, these market participants undoubtedly avoided following the herd. Why did they then follow the herd?

According to an old proverb, "What you know for sure that just ain't so" is what gets you into trouble, not what you don't know. Ironically, most choices mirror those made by the typical investor. That is simply how averages operate. The herd gathers if a large enough number of people think their analysis of a problem is superior (when it is actually just average).

Having a false sense of superiority

An alternative bias to the crowd mentality that can be just as pernicious and is probably more to blame for the GameStop and dogecoin frenzy effects experienced investors. Illusory superiority bias is the name for what is essentially an overconfidence in the excellence and originality of our choice.

Anyone who makes an investing decision supported by a thoughtful thesis typically thinks the choice they made is optimal and correct. Unfortunately, illusory superiority bias frequently distorts our perception of what is ideal, causing an inaccurate assessment of the facts and, consequently, a wrong conclusion. Sometimes, this investing bias even leads us to deliberately or unintentionally ignore evidence that contradicts our thesis, which again leads to a less-than-ideal choice.

Online stock trading and cryptocurrency investors who are accredited are not the only ones who suffer from illusory superiority bias. Due to an overconfidence in one strategy or method of analysis, venture capital and private equity businesses with a lengthy history of success may suddenly find themselves in unprofitable circumstances.

Remaining vigilant

When filling up our deal funnel, keep our investment thesis in mind. When evaluating each opportunity, keep our goal criteria top of mind. Try to spot when the team is following the lead of an outside influence.

Not always an easy task. It entails actively challenging presumptions about the qualities of the perfect investor and sometimes even avoiding the use of well-liked investment techniques. Instead, we should concentrate on results that are defined inside.

Ignore the claims of funds that gave investors returns of 100 times their initial investment, and ignore benchmarks that don't apply to our cohort or fund lifespan. To internally define what success looks like, we create our goals and KPIs, then set out to attain those outcomes.

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