What is... | March 27, 2013

What is herd behaviour?

When sheep or other animals are in a herd, they move together at the same time. Often one or two leaders start, then momentum builds as more and more join until a large group are all heading in the same direction.


A similar idea holds true when investors follow the herd. The investors follow others rushing to buy (or rushing to sell) housing, property, shares or other investments. But simply going with the herd is not likely to be a well-thought through investment strategy. And the followers can end up paying the price.

Herds and investment bubbles
Herd behaviour in investing is sometimes called the conformity trap or following the crowd. If you hear someone explain why they bought by saying “everybody else is doing it”, there is a good chance they are following the herd. In his fifth lesson for investors from the financial crisis, ING global chief economist Mark Cliffe explains how the emotions of greed and fear “can drive asset prices way above or below the levels justified by prospective long-term returns”. Cliffe says investors can get carried away in a boom, at times fuelling an asset bubble, but when the bust comes, there is also a rush to get out.
Herd investing is said to have contributed to many dramatic movements in markets over hundreds of years. Among the most famous examples are the Dutch tulip bulb mania of 1630s, the Japanese asset bubble of the late 1980s, the “dot-com” boom in the late 1990s and the housing market dynamics that contributed the global financial crisis from 2007 onwards.

All together now
A trap may occur when a decision to invest in a particular asset might seem rational to the individual. But individual investment decisions are not made in isolation. If everyone else is doing the same, the collective action of the group might actually be irrational.
Active investors may try to cash-in on herd momentum, buying before prices get pushed up and selling at a profit.
Herd behaviour in financial markets is often studied, with examples of research here, here and here.

I’ll do the opposite
In contrast to herd investing, contrarian investing involves doing the opposite – taking financial positions that are opposite to that of the majority. Billionaire Warren Buffett is considered by many to be the world’s best-known contrarian investor. But beware, this style of investing can be hugely risky, is not for the faint hearted and often only suits certain market conditions.

Plan your own path
Behavioural economics website Nudge tells a humorous illustration of herd behaviour. It recaps an episode of the sitcom King of Queens in which the protagonists follow the herd and invest a Christmas bonus in a high-flying internet stock that “goes up for one day, but quickly falls”. In that instance, following the herd did not pay off. It suggests simply following the crowd can be financially dangerous.
A smarter strategy includes taking account of how financial circumstances, stage in life and attitudes to risk can differ between peers and friends – and how investments might best reflect such differences.

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eZonomics team
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