Behavioral Finance: Key Concepts - Herd Behavior
  1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

Behavioral Finance: Key Concepts - Herd Behavior

By Albert Phung

Key Concept No.5: Herd Behavior
One of the most infamous financial events in recent memory would be the bursting of the internet bubble. However, this wasn't the first time that events like this have happened in the markets.

How could something so catastrophic be allowed to happen over and over again?

The answer to this question can be found in what some people believe to be a hardwired human attribute: herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice.

There are a couple of reasons why herd behavior happens. The first is the social pressure of conformity. You probably know from experience that this can be a powerful force. This is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. Therefore, following the group is an ideal way of becoming a member.

The second reason is the common rationale that it's unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don't. This is especially prevalent in situations in which an individual has very little experience.

The Dotcom Herd
Herd behavior was exhibited in the late 1990s as venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies, even though most of these dotcoms did not (at the time) have financially sound business models. The driving force that seemed to compel these investors to sink their money into such an uncertain venture was the reassurance they got from seeing so many others do the same thing.

A strong herd mentality can even affect financial professionals. The ultimate goal of a money manager is to follow an investment strategy to maximize a client's invested wealth. The problem lies in the amount of scrutiny that money managers receive from their clients whenever a new investment fad pops up. For example, a wealthy client may have heard about an investment gimmick that's gaining notoriety and inquires about whether the money manager employs a similar "strategy".

In many cases, it's tempting for a money manager to follow the herd of investment professionals. After all, if the aforementioned gimmick pans out, his clients will be happy. If it doesn't, that money manager can justify his poor decision by pointing out just how many others were led astray.

The Costs of Being Led Astray
Herd behavior, as the dotcom bubble illustrates, is usually not a very profitable investment strategy. Investors that employ a herd-mentality investment strategy constantly buy and sell their investment assets in pursuit of the newest and hottest investment trends. For example, if a herd investor hears that internet stocks are the best investments right now, he will free up his investment capital and then dump it on internet stocks. If biotech stocks are all the rage six months later, he'll probably move his money again, perhaps before he has even experienced significant appreciation in his internet investments.

Keep in mind that all this frequent buying and selling incurs a substantial amount of transaction costs, which can eat away at available profits. Furthermore, it's extremely difficult to time trades correctly to ensure that you are entering your position right when the trend is starting. By the time a herd investor knows about the newest trend, most other investors have already taken advantage of this news, and the strategy's wealth-maximizing potential has probably already peaked. This means that many herd-following investors will probably be entering into the game too late and are likely to lose money as those at the front of the pack move on to other strategies.

Avoiding the Herd Mentality
While it's tempting to follow the newest investment trends, an investor is generally better off steering clear of the herd. Just because everyone is jumping on a certain investment "bandwagon" doesn't necessarily mean the strategy is correct. Therefore, the soundest advice is to always do your homework before following any trend.

Just remember that particular investments favored by the herd can easily become overvalued because the investment's high values are usually based on optimism and not on the underlying fundamentals. (For related reading, see How Investors Often Cause The Market's Problems.)

Behavioral Finance: Key Concepts - Overconfidence

  1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion
RELATED TERMS
  1. Tight Monetary Policy

    A course of action undertaken by the Federal Reserve to constrict ...
  2. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  3. Sortino Ratio

    A modification of the Sharpe ratio that differentiates harmful ...
  4. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  5. Climate Finance

    Climate finance is a finance channel by which developed economies ...
  6. Financial Modeling

    The process by which a firm constructs a financial representation ...
RELATED FAQS
  1. What are the primary assumptions of Efficient Market Hypothesis?

    The primary assumptions of the efficient market hypothesis (EMH) are that information is universally shared and that stock ... Read Full Answer >>
  2. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  3. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  4. What is the 'Rule of 72'?

    The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of ... Read Full Answer >>
  5. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  6. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center