What is herd behaviour? It’s human nature to want to feel part of a community or group. And, we’re often easily influenced by those around us. We tend to exhibit what’s known as ‘herd mentality.’
When met with uncertainty, the human mind is inclined to seek safety in numbers. In the same way, animals tend to react in a group when faced with danger.
Most of us would like to believe that our choices are based on our own independent judgements. However, this is often not the case. According to a study in the Journal of Consumer Research, we’re prone to copy the actions and even product choices of others.
The study revealed that when people didn’t have a strong existing opinion about a range of available products, they simply copied those around them. Instead of asking questions or researching the options, they adopted the herd behavior response.
Herd behavior & finance
In the context of finance, herd behavior refers to the phenomenon where investors copy the actions of others based on the assumption that those other investors know what they are doing. Herd behavior is one of the most common behavioral biases in finance.
Many investors simply look around and follow what they see others are doing. Rather than relying on their own research and analysis, they gravitate toward similar investments as others. This is based on the tendency to believe that a large group of people couldn’t possibly all be wrong about something. People often feel more confident investing in an asset if everyone around them is doing the same.
How herd behavior affects the market
On a large scale, herd instinct can create bubbles and crashes through panic buying/selling. It can be seen in both market directions. When the number of people investing slows, some will sell, causing others to question their position and sell too. Eventually, this momentum can cause a downside movement.
Herd behavior can also create momentum which may lead to a ‘bubble.’ Massive appreciation causes an asset’s price to rise much higher than its actual intrinsic value. The bubble inflates as capital flows in and people buy. But at some point, confidence is lost, panic sets in, and investors sell their position for fear of further loss. This cascading effect causes massive depreciation in the price and the bubble ‘bursts.’ The crypto market is notorious for herd behavior and is especially evident in the case of meme coins like Dogecoin or Shiba Inu.
How to see the opportunities others miss
Note that it can be profitable to buy something that everyone else is buying, as long as research has been done, and a plan and exit strategy is in place.
But to succeed, it’s necessary to do more than the rest of the herd and to look for opportunities that others miss. Disclaimer: NOT FINANCIAL NOR INVESTMENT ADVICE. Only you are responsible for any capital-related decisions you make and only you are accountable for the results.