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Understanding Herd Behaviour can help us make better financial decisions

Updated: Apr 14, 2020

What is herding?

Herd behaviour is the tendency of individuals to follow the majority. Individual's choices are biased by decisions made by others. Endorsements by influential economic decision makers and institutions create reactions and purchases by masses. The bestseller tag of a book boosts its sales and similarly, people are hired to clap during plays and laugh in sitcoms just to improve the show’s popularity.

The example of nudges that influence herding can be found in all industries but these nudges are most prevalent in industries where consumers lack proper information about the commodity they purchase (asymmetric information).

Herding in Financial Markets

Herd behaviour is more likely in the domain of finance and asset investment. It is an area where people lack specific expertise and also where emotion plays an important role.

Dotcom bubble (1999-2000):

Investors poured huge assets into purchasing stocks in young and fresh Internet companies, even though many of them didn’t have any profit and were unlikely to generate significant revenues in the foreseeable future. Since investors lacked proper means to investigate the legitimacy of these websites, the market popularity of dotcom companies nudged them to make these decisions.

Housing Bubble (2007-08):

There was a global rise in house prices financed by increased levels of borrowing and leverage. House prices grew faster than earnings and affordability, but despite prices becoming divorced from long-term price-earning ratios, several mechanisms kept the bubble going.

Individuals saw rising prices and felt a need to get on the property market to benefit from the rise in prices. Potential homebuyers were encouraged by mortgage companies who had the incentive to keep selling mortgages. There was growth in subprime lending in the US and UK.

The Result? A market crash.

Have we learnt our lesson?

Bitcoin (Ongoing):

Bitcoin is a tradable commodity and its value can fluctuate easily in the market. As the price of a Bitcoin rises, the share value swings in large fluctuations. In 2017, bitcoin went from being worth around $15 billion to $225 as interest in the crypto-currency soared. In the image, it can be seen that the media attention drove the price of bitcoin until the bubble burst.

Old and struggling companies are finding that they can increase the value of their business by announcing spin-offs like Dentacoin (digital coin to use in the dental industry). Kodak, struggling to make the transition from film to digital, has also recently announced their entry into the brave new world of blockchain and cryptocurrency. Just the announcement was sufficient to see the share price increase 200 percent, with volume up 22,000 percent.

There is an element of herding and irrationality with people joining these new ventures giving hints of the past financial crises.

Herding, a psychology present form our origin?

The initial works of herd behaviour can be traced back to 1514, as Eric Hoffer (1955) quoted Machiavelli, “Men nearly always follow the tracks made by others and proceed in their affairs by imitation.” The idea of a group behaviour is also observed in other animal species and can be seen as an origination psychology. A powerful element of human psychology is the desire not to get left behind or miss out. This can encourage people to follow the market sentiment. The fear of having a contradictory view from the herd and being wrong takes a psychological toll and people prefer to follow the herd instead.

Why study herding?

Masses drive the markets but the markets should not drive the masses. If you want to make more money than others, you can’t invest like other people. Being part of the herd is seldom lucrative in the long run. It’s impossible to predict when the herd will change its emotional mind. It is essential to understand when a herd is forming to get a step ahead from the market. The nudge of the herd is powerful but those who can predict the presence of herding that can pursue excellence.

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