Herd behavior

Herd behavior, or ‘following the trend’, occurs when a large group of investors behaves similarly. And although the investors are simultaneously buying (or selling) the same securities, there is no coordination from above happening. Herd behaviour typically occurs because investors are copying the behavior of other investors.

Potential causes

One obvious reason why investors might want to copy the behavior of other investors is asymmetric information. Copying the actions of other investors and giving into herd behavior can be a rational strategy if you think other investors know something that you don’t know yet. For example, suppose you’ve been following a stock for quite some time now. However, the last couple of days, volume in the stock has been increasing and more and more investors decide to buy the stock. Although you don’t know what new information is causing people to buy, you might be tempted to buy as well. All these other investors buying can’t be wrong, right? So you decide to buy as well, and our buy order might inspire other investors to buy as well.

At the same time, it’s possible that the information that triggered all this buying does not justify such a big price increase. As such, the price of the security might have increased too much.

Risks

Herd behavior can lead to lower returns. By the time you notice an upward trend and are able to react to it, other people will already have taken advantage of much of the increase. This means that further upward potential might be limited. Also, if investors suddenly realize that the security is overvalued, they might decide to sell. In that case, the trend reverses and you might lose money. Another reason why herding behaviour leads to lower returns, is because it causes you to trade more. You will then incur transaction costs and you might be buying stocks you otherwise might not have bought.

Related theories

Herd behaviour is closely related to another theory in behavioral finance; the greater fool theory.

Summary

Herd behavior is a dangerous phenomenon in financial markets. It can cause securities to become overvalued, and the inevitable correction can lead to serious losses in wealth.

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