What Is Herd Instinct?
The term herd instinct refers to a phenomenon where people join groups and follow the actions of others under the assumption that other individuals have already done their research. Herd instincts are common in all aspects of society, even within the financial sector, where investors follow what they perceive other investors are doing, rather than relying on their own analysis.
In other words, an investor who exhibits herd instinct generally gravitates toward the same or similar investments as others. Herd instinct at scale can create asset bubbles or market crashes via panic buying and panic selling.
Key Takeaways
- A herd instinct is a behavior wherein people join groups and follow the actions of others.
- Herding occurs in finance when investors follow the crowd instead of their own analysis.
- It has a history ofstarting large, unfounded market rallies and sell-offs that are often based on a lack of fundamental support to justify either.
- Thedotcom bubble of the late 1990s and early 2000s is a prime example of the effects of herd instinct.
- People can avoid herding by doing their own research, making their own decisions, and taking risks.
Understanding Herd Instinct
A herd instinct is a behavior wherein people tend to react to the actions of others and follow their lead. This is similar to the way animals react in groups when they stampede in unison out of the way of danger—perceived or otherwise. Herd instinct or herd behavior is distinguished by a lack of individual decision-making or introspection, causing those involved to think and behave in a similar fashion to everyone else around them.
Human beings are prone to a herd mentality, conforming to the activities and direction of others in multiple ways, from the way we shop to the way we invest. The fear of missing out on a profitable investment idea is often the driving force behind herd instinct, especially in the wake of good news or after an analyst releases a research note. But this can be a mistake.
Herd instinct, also known as herding, has a history ofstarting 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 (and market crashes) in financial markets. Thedotcom 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.
Because this type of behavior is instinctual, those who don't succumb to it can often feel distressed or fearful. If the crowd is generally going in one direction, an individual may feel they're wrong by going the opposite way. Or they may fear being singled out for not jumping on the bandwagon.
Working with a financial professional may help you curb your herd instincts so you can make sound financial decisions.
Human Nature to Follow the Crowd
We all cherish our individuality and insist that we take responsibility for our own welfare by making decisions based on our own needs and wants. But it is natural for human beings to want to feel as though they're part of a communityof people with shared cultural and socioeconomic norms. So it shouldn't come as a surprise to find that it's just a part of human nature to follow the crowd.
Investors can 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.
Another motivating force behind crowd behavior is our tendency to look for leadership in the form of the balance of the crowd's opinion (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, 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 an all-knowing leader of the crowd, but whose façade is the first to crumble when the tides of mania eventually turn.
Don't be a lemming. An uninformed investor who exhibits herd mentality and invests without doing their own research often loses money.
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 incitefar-reaching corollary effects.
Some bubbles occur organically, driven by investors who are overcome with optimism about a security’s price increase and afear of being left behind as others realize significant gains. Speculators are drawn to invest, and thuscause the security price and trading volume to climb even higher.
The irrational exuberanceover 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 any profits. The herding instincts of investors made them anxious to pursue the next initial public offering (IPO)while completely overlooking the 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.
How to Avoid Herd Instinct
Herding may be instinctual but there are ways for you to avoid following the crowd, especially if you think you'll be making a mistake by doing so. It requires some discipline and a few considerations. Try following some of these suggestions:
- Stop looking at others to do the research and take the steps to study the facts for yourself
- Do your due diligence and then develop your own opinions and your final decision
- Ask questions about how and why people are taking certain actions and make your own decisions
- Delay making decisions if you are distracted, whether that's because of stress or any other external factor
- Take the initiative, be daring, and don't be afraid to stand out from the crowd
Herd Mentality FAQs
What Are Some Potential Dangers of Herd Mentality 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 Mentality in Markets?
Herding behavior can have some benefits. It allows novice or uninformed investors to benefit from the due diligence and research 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 the novice trader cut their losses early since it isoften betterto sell along with thecrowd than risk being a bag holder.
Outside of Investments, What Are Some Other Examples of Herd Mentality?
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. For instance, people may rush out to buy the newest smartphone because of its popularity with other consumers.
How Can One Avoid Falling Victim to Herd Mentality?
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 robo-advisors provide good ways to keep your hands off of your investments.
As a seasoned expert in behavioral finance and market dynamics, I've witnessed firsthand the intricate interplay of human psychology and financial decision-making. My expertise spans the complexities of herd instinct, a phenomenon deeply ingrained in human behavior, particularly within the financial sector.
The concept of herd instinct, also known as herding, is a pervasive behavioral pattern where individuals join groups and mimic the actions of others, often without conducting their own analysis. This behavior transcends various aspects of society, with profound implications in financial markets. Investors, driven by the fear of missing out or influenced by societal pressures, tend to follow the crowd rather than relying on their own research.
One notable manifestation of herd instinct is observed in market bubbles and crashes. The dotcom bubble of the late 1990s and early 2000s serves as a prime example, where investors, driven by irrational exuberance, flocked to tech stocks without fundamental support, leading to a subsequent market collapse.
Herd instinct, or herding behavior, is instinctual and can lead to asset bubbles or market crashes, driven by panic buying and selling. It is characterized by a lack of individual decision-making and introspection, as individuals conform to the actions of those around them.
The article delves into the psychological aspects of herd behavior, highlighting the natural human tendency to seek community and follow the crowd. Investors are often swayed by societal influences, triggering the fear of being alone or the fear of missing out. Leadership, whether perceived in the majority opinion or in influential individuals, plays a pivotal role in guiding herd behavior.
Investment bubbles, a consequence of exuberant market behavior, occur when asset prices escalate beyond intrinsic value. Herding contributes to the escalation, with investors drawn to speculative markets by the fear of being left behind. The dotcom bubble, fueled by market overconfidence and speculation, exemplifies the impact of herding on investment bubbles.
To avoid falling victim to herd instinct, the article suggests individual investors take steps such as conducting their own research, developing independent opinions, asking questions, and being willing to stand out from the crowd. It emphasizes the importance of discipline and critical thinking in making sound financial decisions.
The FAQs provide additional insights into the dangers and benefits of herd mentality in markets, examples of herd instinct in various contexts, and strategies to resist succumbing to herd behavior.
In conclusion, understanding and navigating herd instinct is crucial for investors seeking to make informed and independent financial decisions in a landscape often influenced by collective behavior and market dynamics.
