In the dynamic landscape of Sri Lanka’s financial sector, informal investment schemes have emerged as a prominent vehicle for wealth creation. These schemes often operate outside the formal financial system, attracting a wide array of investors due to promises of higher returns and lower entry barriers.
However, underlying these informal schemes is a psychological trap investors often fall into because of herding behaviour. This phenomenon, where individuals blindly follow the actions of others rather than making independent decisions, has proven to be a significant driver of irrational investment choices, leading to substantial financial losses. As Sri Lankans are affected by the aftereffects of economic challenges, understanding herding behavior in these networks is critical.
Informal investment schemes
Informal investment networks in Sri Lanka have been thriving for decades. These schemes are often marketed through community trust and word-of-mouth communication among those who lack access to formal banking systems or prefer informal setups’ simplicity and perceived profitability. With investments ranging from real estate to Rotating Savings and Credit Associations (ROSCAs), these platforms promise high returns in a relatively short period. Unfortunately, their unregulated nature leaves investors exposed to considerable risks.
Herding behavior, deeply rooted in human psychology, plays a pivotal role in the decision-making processes of these investors. Whether driven by a fear of missing out or relying on social proof, individuals often ignore rational analysis and follow the crowd, leading to unsustainable investment bubbles and eventual collapse.
Understanding behavioral finance biases
Human judgments are subjected to the many biases, specially in financial decision making. The concept of herding in investment behavior is extensively studied within the field of behavioral finance. According to Prospect Theory, individuals weigh losses more heavily than gains, leading them to irrationally follow the actions of others in the hope of minimizing potential losses. This is particularly prevalent in Sri Lanka’s informal investment schemes, where investors often lack comprehensive financial literacy.
An example can be seen in the behavior surrounding Rotating Savings and Credit Associations (ROSCAs), which are widely popular in rural Sri Lanka. In these informal savings clubs, members contribute regularly to a collective fund, and one member receives the entire pool of contributions on a rotating basis. While these setups have roots in community trust and mutual support, they also encourage herd-like participation. Once a few individuals benefit, others flock to the scheme, often disregarding potential pitfalls like mismanagement or defaults by members.
Recent studies pointed out a strong link between herding behavior and behavioral biases such as the disposition effect, where investors hold onto losing investments in the hope of recouping losses, and blue-chip stock favoritism. These biases, often observed in formal markets, are even more pronounced in informal settings where reliable information is scarce.
The ripple effect of herding behaviour
The implications of herding behavior are far-reaching. In the absence of proper regulation, the collapse of one informal scheme can trigger a domino effect, leading to widespread financial ruin. This was seen in some pyramid schemes like Sport Chain App, OnmaxDT and MFTE SL Group which were recently banned by the Central Bank of Sri Lanka, where the failure of an informal financial schemes led to losses amounting to over billions of rupees, affecting nearly thousands of investors. Many of these individuals had joined the scheme based on the actions of their peers, without fully understanding the risks involved.
Recent discoveries by researchers emphasize that herding can exacerbate externalities within investment networks. When individuals rely on others’ actions rather than conducting their due diligence, it creates an environment where risky investments are perpetuated, inflating asset bubbles. In Sri Lanka, such bubbles often form around real estate or informal lending schemes, where the desirability of quick profits blinds investors to the underlying risks.
Why do investors herd?
Several factors contribute to the prevalence of herding behavior in Sri Lanka’s informal investment networks. One of the primary drivers is a lack of financial literacy. Many investors, particularly in rural areas, lack the tools to assess the risk and return profile of investments independently. Instead, they rely on the actions of their peers or community leaders, assuming that the collective knowledge will lead to the best outcomes.
Additionally, the informal nature of these schemes means that they are often masked in cloudiness. Without access to clear, reliable information, investors are left to speculate based on the limited data they can gather from their peers. This creates a feedback loop, where individuals are more likely to make decisions based on observed behavior rather than a thorough analysis of the available information.
Scholarly evidence shows that in many cases, herding is not just a result of irrationality but rather a strategic complement to the actions of others. Investors may believe that by following the crowd, they are minimizing their individual risk, as the collective wisdom of the group is assumed to be superior. This belief is particularly dangerous in informal networks, where due diligence is often sacrificed in favor of trust.
A recipe for disaster?
While herding behavior might seem like a rational strategy in the short term, it is ultimately unsustainable. Informal investment networks in Sri Lanka are highly susceptible to shocks, given their lack of regulatory oversight. Once an investment bubble bursts, those who have blindly followed the crowd often find themselves at a significant financial loss.
Experts and specialists evaluate the role of digital technology in financial services, which could offer a solution to the problems posed by herding. By increasing access to information and promoting transparency, technology could empower individuals to make more informed investment decisions, thereby reducing the likelihood of herd-driven financial collapses. However, until such innovations become widely available, the risks posed by herding behavior in Sri Lanka’s informal investment schemes remain high.
Navigating the risks
Herding behavior, while deep-rooted in human psychology, poses a significant threat to the stability of Sri Lanka’s informal investment networks. The lack of financial literacy and the complicated nature of these schemes create an environment where individuals are more likely to follow the crowd than make independent, informed decisions.
As history has shown, this behavior can lead to disastrous outcomes, with entire communities suffering the consequences of a single scheme’s collapse. To mitigate these risks, efforts must be taken to improve financial literacy, empower accessibility and promote transparency within formal investment networks. Sri Lanka can only avoid the pitfalls of herding behavior by equipping individuals with the tools for rational, informed investment decisions.