We all tend to do what everyone else does, even when we can see that everyone else is wrong. In financial markets, this can lead to bubbles and herd behaviour. It is important to be aware of this tendency within our psychology, so you can at appropriate times avoid joining in the bubbles. It is important to do this because you will lose a lot of money if you participate or, once in, fail to exit before everyone else does.
In this post, I will briefly outline the relevant psychology so you can both look for the effects in your own thinking and expect those same effects in other market participants. This will improve your trading. I discuss this bias and many others in a financial markets context in my new book (see link below).
Conformity Bias is also known in the literature as the Asch Effect, after the pioneer experimenter. Asch obtained really surprising results, which will show you how strong this effect is. He had a naive member of the public sit in a room in front of a blackboard with four other people. The member of the public thought that the other four people were also naive members of the public, but in reality they were actors who were going to behave in a specific way suggested by Asch.
A line of a certain length was drawn on the left side blackboard. Some other reference lines of different lengths were drawn on the right hand side. One of them was clearly the same length as the reference line and all of the rest were clearly much shorter or much longer. Asch then had the people say which of the test lines on the right was the same length as the reference line.
If the naive member of the public went last and heard all of the actors give a wrong answer, he tended to go along with them even though the answer was obviously and clearly wrong. Amazingly, Asch found that most people gave an obviously wrong answer some of the time and also that some people gave wrong answers most of the time.
This is how strong Conformity Bias is: it works even when the answer is obvious. Imagine how much more dangerous it is in financial markets where the answers are much less clear cut and much ambiguous and conflicting data must be weighed.
I think this is one factor behind a lot of famous bubbles in financial history. Right now, it looks to me as though the cryptocurrencies, most notably Bitcoin, are exhibiting bubble characteristics. One sign of this is the enthusiasm of a particular football manager, one noted for his lack of financial acumen, for Ethereum. I do not say this is a scam; I merely suggest that one should look to more fundamental underpinnings for value than “everyone likes it and it has gone up a lot.”
Avoid Conformity Bias and trade better by trading the other way when you see it happening.