What is 'Herd Instinct'
Herd instinct is a mentality characterized by a lack of individual decision-making or thoughtfulness, causing people to think and act in the same way as the majority of those around them. In finance, a herd instinct relates to instances in which individuals gravitate to the same or similar investments based almost solely on the fact that many others are investing in those stocks. The fear of regret of missing out on a good investment is often a driving force behind herd instinct.
BREAKING DOWN 'Herd Instinct'Also known as herding, such investor behavior can often cause large unsubstantiated rallies or selloffs based on seemingly little fundamental evidence to justify either. Herd instinct is the primary cause of bubbles in finance. For example, many look at the dotcom bubble of the late 1990s and early 2000s as a prime example of the ramifications of herd instinct in the development and subsequent pop of that industry's bubble.
Herding Is Natural
Humans naturally want to belong to a community, a group of people with shared cultured and socioeconomic norms. At the same time, people still prize their individuality and sense of responsibility for their own welfare. However, investors can sometimes be induced into following the herd, whether it is buying at the top of a market rally or going over the cliff in a market crash. Financial behaviorists attribute this to the natural human tendency to fear being left alone or the fear of missing out. It could also come down to the raw, powerful emotions of fear, greed and envy that drive people to irrational states of mind.
Herding and Investment Bubbles
An investment bubble results from a rapid escalation in price of an asset over its intrinsic value, which is caused by exuberant market behavior perpetuated through a positive feedback loop. The bubble inflates until the asset price reaches a level beyond economical rationality when further increases in price are contingent purely on investors continuing to buy in at the highest price. When no more investors can be found to buy at that price level, the bubble begins to collapse. In highly speculative markets, the collapse can occur quickly with far-reaching corollary effects.
Some bubbles occur organically, driven by investors overcome with optimism about an asset's price rise and their fear of being left behind as others reap huge gains. Eventually, speculators are drawn in, and they can drive the price and volume even higher. The fervor over dotcom stocks in the late 1990s was driven by cheap money, easy capital, market overconfidence and pure speculation. It did not matter to investors that most dotcom startups were not generating any revenues, much less profits. The herding instincts of investors made them anxious to get involved in the next initial public offering (IPO), overlooking traditional fundamentals. Just as the market peaked, investment capital began to dry up, which led to the bursting of the bubble.