What is Herd Instinct
Herd instinct is a mentality that is distinguished by a lack of individual decision-making or introspection, causing people to think and behave in similar fashion to those around them. In finance, a herd instinct relates to instances in which investors gravitate toward the same or similar investments based almost solely on the fact that many others are buying the securities. The fear of missing out on a profitable investment idea is often the driving force behind herd instinct.
BREAKING DOWN Herd Instinct
Herd instinct, also known as herding, has a history of starting large, unfounded market rallies and selloffs 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.
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 fear being alone or the fear of missing out.
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 over-speculation. 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.