What Is Herd Instinct?
In finance, herd instinct, or herding behavior, is a phenomenon where investors follow what they perceive other investors are doing, rather than relying on their own analysis. In other words, an investor exhibiting herd instinct will gravitate toward the same or similar investments as others based almost solely on the fact that those others are buying the securities. Herd instinct at scale can create asset bubbles or market crashes via panic buying and panic selling.
- Herd instinct in finance occurs when investors begin following the crowd instead of their own analysis.
- Herd instinct has a history of starting large, unfounded market rallies and sell-offs that are often based on a lack of fundamental support to justify either.
- The dotcom bubble of the late 1990s and early 2000s is a prime example of the ramifications of herd instinct in the growth and subsequent bursting of that industry's bubble.
Trade Forex On Herd Instinct
Understanding Herd Instinct
Human beings are prone to a herd mentality, conforming to the activities and direction of others. This, however, can be a mistake in investing. Herd instinct is a mentality that is distinguished by a lack of individual decision-making or introspection, causing people to think and behave in a similar fashion to those around them. The fear of missing out on a profitable investment idea is often the driving force behind herd instinct.
Herd instinct, also known as herding, has a history of starting large, unfounded market rallies and sell-offs that are often based on a lack of fundamental support to justify either. Herd instinct is a significant driver of asset bubbles in financial markets. The dotcom bubble of the late 1990s and early 2000s is a prime example of the ramifications of herd instinct in the growth and subsequent bursting of that industry's bubble.
Human Nature to Follow the Crowd
By nature, human beings want to be part of a community of people with shared cultured and socioeconomic norms. Nevertheless, people still cherish their individuality and taking responsibility for their own welfare. Investors can occasionally be induced into following the herd, whether through buying at the top of a market rally or jumping off the ship in a market sell-off. Behavioral finance theory attributes this conduct to the natural human tendency to be swayed by societal influences that trigger the fear of being alone or the fear of missing out (FOMO).
Don't be a lemming. A lemming refers to an uninformed investor who exhibits herd mentality and invests without doing their own research, often leading to losses.
Another motivating force behind crowd behavior is our tendency to look for leadership in the form of the balance of the crowd's opinion (as we think that the majority must be right) or in the form of a few key individuals who seem to be driving the crowd's behavior by virtue of their uncanny ability to predict the future. In times of uncertainty (and what is more uncertain than the multitude of choices facing us in the trading universe?), we look to strong leaders to guide our behavior and provide examples to follow. The seemingly omniscient market guru is but one example of the type of individual who purports to stand as all-knowing leader of the crowd, but whose façade is the first to crumble when the tides of mania eventually turn.
Herding and Investment Bubbles
An investment bubble occurs when exuberant market behavior drives a rapid escalation in the price of an asset above and beyond its intrinsic value. The bubble continues to inflate until the asset price reaches a level beyond fundamental and economical rationality. At this stage in a bubble’s existence, further increases in the cost of the asset often are contingent purely on investors continuing to buy in at the highest price. When investors are no longer willing to buy at that price level, the bubble begins to collapse. In speculative markets, the burst can incite far-reaching corollary effects.
Some bubbles occur organically, driven by investors who are overcome with optimism about a security’s price increase and a fear of being left behind as others realize significant gains. Speculators are drawn to invest, and thus cause the security price and trading volume to climb even higher. The irrational exuberance over dotcom stocks in the late 1990s was driven by cheap money, easy capital, market overconfidence, and overspeculation. It did not matter to investors that many dotcoms were generating no revenue, much less profits. The herding instincts of investors made them anxious to pursue the next initial public offering (IPO) while completely overlooking traditional fundamentals of investing. Just as the market peaked, investment capital began to dry up, which led to the bursting of the bubble and steep investment losses.
Frequently Asked Questions
What are some potential dangers of herd instinct in markets?
Herding, or following the crowd, can cause trends to amplify well-beyond fundamentals. As people pile into investments for fear of missing out, or because they have heard something positive but have not actually done their own due diligence, prices can skyrocket. This "irrational exuberance" can lead to unstable asset bubbles that ultimately pop. In reverse, sell-offs can turn into market crashes as people pile in to sell for no other reason than others are doing so, which can turn into panic selling.
What are some positives of herd instinct?
At the same time, herding behavior can have some benefits. It allows novice or uninformed investors to benefit from the due diligence of others. Passive index investing, for instance, is a herding-type strategy that relies on simply matching the broader market's performance. Herd instinct can also let a novice trader cut their losses early since it is often better to sell along with the crowd than risk being a bag holder.
Outside of investments, what are other examples of herd instinct?
Herd instinct appears in several contexts, and throughout human history. Aside from various asset bubbles and manias, herding can help explain mob behavior or riots, fads, conspiracy theories, mass delusions, political and social movements, sports fandom, and many others.
How can one avoid falling victim to herd instinct?
A good way to avoid this is to make investment decisions that are based on sound, objective criteria and not let emotions take over. Another way is to adopt a contrarian strategy, whereby you buy when others are panicking - picking up assets while they are "on-sale", and selling when euphoria leads to bubbles. At the end of the day, it is human nature to be part of a crowd, and so it can be difficult to resist the urge to deviate from your plan. Passive investments and roboadvisors provide good ways to keep your hands off of your investments.