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.

RELATED TERMS
  1. Behavioral Finance

    Behavioral finance is a field of finance that proposes psychology-based ...
  2. Speculative Bubble

    A speculative bubble is a spike in asset values within a particular ...
  3. Internet Bubble

    The internet bubble, also known as the dot-com bubble, is a textbook ...
  4. Bubble Company

    A bubble company is one whose valuation greatly exceeds that ...
  5. South Sea Bubble

    The South Sea Bubble was an 18th century stock scam in Britain ...
  6. Tragedy Of The Commons

    Tragedy of the commons refers to an economic problem in which ...
Related Articles
  1. Trading

    Herd Instinct Often A Good Guide For Forex

    Use caution and commonsense when making trades according to herd instinct – use stop losses, avoid complacency and plan your exit strategy.
  2. Investing

    Economic Bubble: Toil And Trouble!

    You might like the idea of profiting from a bubble, but you’d probably like to avoid suffering from its aftermath. Here is how an economic bubble works.
  3. Insights

    Five Of The Largest Asset Bubbles In History

    The five bubbles discussed here were among the biggest in history; their lessons should be heeded.
  4. Tech

    Is the Cryptocurrency Bubble More Like Housing or Dotcom?

    Many investors believe cryptocurrencies are a bubble phenomenon, but which historical bubble does it resemble?
  5. Insights

    How Do Asset Bubbles Cause Recessions?

    Understand how asset bubbles often lead to deep, protracted recessions. Read about historical examples of recessions preceded by asset bubbles.
  6. Investing

    Investing During Market Bubbles and Bursts

    Don’t fear bubbles and don’t avoid certain markets because some people believe they may burst.
  7. Insights

    Some Industries Are More Bubbly Than Others

    Investors who want to avoid future bubbles should learn from the past in order to protect their investments.
  8. Insights

    4 Reasons Why Irrational Exuberance Lasts

    20 years ago, Alan Greenspan gave his famous "irrational exuberance" speech, but asset bubbles take a long time to pop.
  9. Insights

    5 Ways To Spot The Next Stock Bubble - And Avoid It

    Playing a market bubble could pay off, but it carries a lot of risk. Avoiding it could be the way to stay profitable.
RELATED FAQS
  1. Can the Efficient Market Hypothesis explain economic bubbles?

    Learn about the nuanced relationship between the efficient market hypothesis and economic bubbles and the requirements and ... Read Answer >>
  2. What burst the Mississippi bubble?

    The Mississippi bubble is actually more of a currency blunder than a true speculative bubble. Read Answer >>
Trading Center