Herd Behavior or Herding

Mostly, such conformity is a good thing and it’s one of the reasons that societies are able to function (legal system, driving, etc).  Nevertheless, watch out for what you step into when you follow the herd.

Herd behavior occurs when investors follow the behavior of a larger group, even in situations which may be difficult to rationally justify the decisions of the group.

A classic example of herd behavior occurred in the late 1990s.  Investors poured huge assets into stocks of young fresh Internet companies, even though many of them didn’t have any profit and were unlikely to generate significant revenues in the foreseeable future.

herding-behaviorAs this example is so long past and our memories so short, herds did the same in 2007/2008.  Who knows, perhaps the herds are at it again right now.

There are many adverse consequences of herd behavior.  They include high transaction costs (which happens) when everyone tries to keep pace with the latest trends.  Focusing on the conduct of the herd in the stock market—instead of on fundamentals that might have more relevant considerations—will likely result in disappointing returns.

Investment ideas, like yawns, are contagious.  Merely being part of a group makes us less inclined to ask the relevant questions. Yes, being part of the herd is fun while it lasts, but it’s seldom lucrative for very long, and it’s impossible to predict when the herd will change its ‘mind.’

If you want to make more money than other people, you can’t invest like other people.

Don’t be lazy!  Start up your trustful brain and do your own thinking.

Sometimes, people make mistakes because they behave like sheep and sometimes they err because they behave like mules.

“If 50 million people say something foolish, it is still foolish.” – W. Sommerset Maughan

2 Comments

  1. Dear Andy,

    I have a question about “Herd behaviour”.

    You explained that it isn’t always the best thing to follow the so called herd of traders when investing into stocks.

    My question now is; does the same principle work when selling stocks? In other words, when everyone starts selling their stocks is it smart to keep the investment or should one sell their stocks because everyone else does?

    Kind regards,

    Eric Klein

    • Dear Eric,

      Yes, exactly. You got it. What you do after you have bought a stock makes a much bigger difference than finding the right entry (and people do spend so much time on this single – not decisive – aspect of investing).
      Always think for yourself before you act. Certainly easier said than done as “masses are always breeding grounds of psychic epidemics”. Don’t get swepted away by them.
      You may want to read the post on the “False Consensus Bias” to learn a bit more about this aspect.

      Keep the questions coming

      Andy

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