What Is Herd Instinct?

What Is Herd Instinct?

by Chad Hassinger on May 24, 2021

Finance, Estate Planning, Estate Planning

By ADAM HAYES
May 20, 2021

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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.

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 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 effects of herd instinct in the growth and subsequent bursting of that industry's bubble.
  • People can avoid herding by doing their own research, making their own decisions, and taking risks.

 

An investor who exhibits herd instinct generally gravitates toward the same or similar investments as others based almost solely on the fact that those others are buying the securities.1 Herd instinct at scale can create asset bubbles or market crashes via panic buying and panic selling.2

 

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 many parts of their lives, from the way we shop to the way we invest. The fear and idea 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.1 But this can be a mistake.

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 (and market crashes) in financial markets.2 For instance, 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.

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, individuals may feel as though they're wrong by going the opposite way. Or they may fear being singled out for not jumping on the bandwagon.3 Investors may feel as though they're making a big mistake if they don't follow the crowd when others sell off their positions in a particular stock.

Important: 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 community of 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.4 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 (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.5

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 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.6

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.6,2

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.6,4

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 any 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.

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.7 Try following some of these suggestions:

  • stop looking at others to do the research for yourself 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 crowd8,7

 

Frequently Asked Questions


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 is often better to sell along with the crowd 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.

 

 


 

Article Sources:

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  1. CFI. "Herd Mentality." Accessed May 19, 2021.
  2. CMI MIC Funds. "HERD MENTALITY." Accessed May 19, 2021.
  3. Zacks. "How Do I Work With Real Time Stock Market Data?" Accessed May 19, 2021.
  4. Zacks. "Herd Behavior in the Stock Market." Accessed May 19, 2021.
  5. LiveScience. "Follow the Leader: Democracy in Herd Mentality." Accessed May 19, 2021.
  6. Morningstar. "How Herding Leads to Market Bubbles." Accessed May 19, 2021.
  7. Finology. "Herd Mentality Bias: How it affects your Investment Decision." Accessed May 19, 2021.
  8. Forbes. "Study Shows The Power Of Social Influence: 5 Ways To Avoid The Herd Mentality." Accessed May 19, 2021.

 

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