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The Lemming Effect and Its Impact on Financial Planning

Daehong Kwon, CFP, KoreaBy Daehong Kwon, CFP, Korea

Recently there have been an increasing number of attempts made to integrate behavioral finance into financial planning. It is indeed only recent that behavioral finance has been systemized as a science, getting a lot of limelight, even though studies on human behavior and psychology have been done for a very long time.

I have learned from my experiences of talking to clients that knowing something is one thing and putting it to action is quite another. More indicative of the limitation of human beings than making a mistake due to lack of knowledge might be making one even with knowledge. One good example that is often cited is when investors purchase stock at the peak of the market and sell stock at the bottom of the market because they’ve failed to manage their greed or fear.

Cohort Psychology

While individual psychology remains a problem, in Korea a sense of cohort is so strong that an individual’s actions tend to be swayed by ‘cohort psychology.’ When something becomes vogue, everybody does it, and even though one does not need to do it, people feel pressure to do what others are doing. Some good examples of this include the rapid demand of smart phones and the patterns of consumption of automobiles and brand-name products. When manifested in good ways, cohort psychology helps entail a concerted effort to materialize a global best-seller status of a product or an extraordinarily spirited atmosphere by immense crowds as shown by the cheering Koreans in every street during the 2002 World Cup. Some even look to Korea as the best country to capitalize on cohort intelligence.

On the other hand, there is a negative element when cohort psychology prevails over an individual’s opinion or propensity in too many ways. People feel scared of being isolated when they don’t have something that everyone else does. A belief that following what everybody else is doing is a safe choice is lurking behind this psychology. Thus, jumping on the bandwagon gives psychological comfort and security. This philosophy explains Koreans’ general refusal to ‘stand out’ in crowds.

Their alertness to not standing out in crowds, however, should not equally apply to an individual’s financial planning. Signing up for a financial product that others have signed up for or checking out the opinions of the majority on the internet is not very helpful.

The Lemming Effect

Lemmings are small mouse-like rodents living in Northern Europe — living together in huge company. They periodically move in mass migrations through the prairie, and display an extraordinary scene that if the leading drove jumps off a cliff to death, the ones behind follow suit in an exact manner. Their behavior would make one laugh, but ironically, the behavior of human beings is no different.

Behind this kind of behavior is crowd psychology. Research shows that mice are very sensitive animals possessing the instinct to get off a boat before it goes out to the sea to avoid drowning. Given this, the lemming effect, which prevails over their instinct, proves to be a scary manifestation of crowd psychology.

In financial planning, it seems that there are not many individuals who have the will to fight off crowd psychology when confronted with the task of buying and selling investment products or devising an insurance plan. Already owning a good insurance product, people will often be misled by a mass media report that tells otherwise or be lured to a new product that is marketed cleverly as a more beneficial one.

What would come to one’s mind if he, not being one of the lemmings in mass, puts himself in a distant position to watch his flocks jumping off a cliff?

After all, it is my hope that integrating behavioral finance into financial planning will produce many positive results going forward that will be helpful for both financial planners and clients.

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