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  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

By Nathan Reiff

One of the most notorious financial events in the past several years was the financial crisis of 2008, which involved a real estate bubble which burst. This was not the first time that events like this have taken place in the markets, and it’s unlikely to be the last. The question, then, is how could something as catastrophic as this happen over and over again?

Part of the answer to this question is attributable to a hardwired human tendency: herd behavior. Herd behavior represents the tendency for an individual to mimic the actions of a larger group, whether those actions are rational or irrational. In many cases, herd behavior is a set of decisions and actions that an individual would not necessarily make on his or her own.

Why does herd behavior happen, particularly if it results in harmful or irrational actions? One reason is that there is a strong social pressure afforded to conformity. This pressure is likely familiar to many of us, as most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. Following the group and its behavior seems to be a natural way of becoming a member of that group.

Another reason for herd behavior is the rationale that the more people buy into a decision, the less likely it is that the decision is incorrect. Even if an individual believes that the action is irrational or inadvisable, he or she is more likely to be swayed if others have already engaged in that behavior. When an individual has little experience or expertise in an area, this behavior can become even more prevalent.

The Dotcom Herd

A prominent example of herd mentality in the financial and investing worlds was the dotcom bubble in the late 1990s. Venture capitalists and private investors made frantic moves to invest huge amounts of money into internet companies, in spite of the fact that many of those dotcoms didn’t have business models that were financially sound. The reason many investors moved their money in this way likely has something to do with the reassurance they received from seeing so many other investors do the same thing. Critics of the cryptocurrency boom of recent years suggest that a similar phenomenon may be taking place in that space. (For more, see How to Find Your Next Cryptocurrency Investment)

We’re all subject to herd mentality, even financial professionals. The primary goal of a money manager is to adhere to an investment strategy in order to maximize a client’s wealth. These clients may exert pressure upon money managers to “buy in” to new investment fads as they come about. A wealthy client may hear about an investment gimmick which is gaining popularity and then inquire with a money manager about whether that manager employs a similar strategy. Money managers thus feel pressure to follow general trends.

The Costs of Being Led Astray

In many cases, herd behavior is not a sound or profitable investment strategy. Investors who are easily swayed by the herd tend to buy and sell assets frequently as they chase the latest investment trends. These investors tend to free up as much investment capital to put all of their money into the latest sector, company, or strategy, switching when the next fad comes along.

A downside to this type of behavior is that the frequent buying and selling tends to incur a substantial amount of transaction costs, eating away at potential profits. That’s to say nothing of the rationality of focusing one’s investments so densely in one area at a time, as well. It is extraordinarily difficult to time trades such that an investor enters a position when the trend is starting. Most herd investors only find out about the latest trend after other investors have taken advantage of it, and the strategy’s potential for generating wealth has likely come and gone.

Avoiding the Herd Mentality

All investors feel some temptation to follow the latest investment trends. However, investors who steer clear of the herd and maintain their own independent strategies and investment principles are likely to avoid the heartbreak that can come with being involved in an investment trend gone wrong. The best advice is to always do your homework before buying in to any trend. (For related reading, see How Investors Often Cause The Market's Problems.)

Behavioral Finance: Key Concepts - Overconfidence
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