Herd Behavior in Financial Markets: What Do We Do Wrong?

Herd behavior

Herd behavior describes human behavior that is influence by a large number of people. Consciously or unconsciously they acting the same way at the same time that is beyond the rationality, as people’s actions are driven by emotion rather than by thinking through a situation.

To understand this concept better, let’s examine the example of two restaurants. “Bonnie” and “Clyde” are on the same street, next to each other. Both are equally good, and provide same cuisine. The first one, however, is full of people while the second one is empty. When you try to decide where to dine your ultimate choice would be “Bonnie”. Since it already has customers you presume that it ought to be better. Anyone else who comes after you will likely also reach the same conclusion and will decide to go for “Bonnie”. You might be disappointed if you find out that the people’s decision to dine at “Bonnie” is just a poor randomness. When the first guest appeared in the neighborhood, (s)he randomly chose “Bonnie” and every other customer followed the same lead. This is a simple illustration showing the impact of collective thinking.

The term “herd behavior” comes from the behavior of animals when they are in danger. All of the animals group together and, in panic mode, move as a unit. Humans also become a part of a herd when they find themselves in a dangerous situations, such as fire, flood or other natural disaster. They mimic the actions of others without any thinking and move in an uncontrolled way, ignoring all the alternative, better, options to save their lives. Herd behavior is most common when massive public gathering takes place. People are easily affected by political or religious manipulations and talk and act in a way that might not happen in other cases.

There are two main reasons that explain why individuals have a herd mentality. One reason is that there is a strong social pressure that is familiar to many of us, thus most people have a natural desire to be accepted by a group. As a result continuously or uncontinuously they mimic actions of others rather than be branded as an outcast. Following the group and its behavior seems to be a natural way of becoming a member of that group. Another reason seems to be more rational follows the logic that the more people buy into a decision, the less likely it is that the decision is incorrect. Such conclusion is more prevalent among those individuals who have a little experience or expertise in an area and feel insecure.

Herd behavior and financial markets 

Herd behavior is also common in financial sector. Most of the time due to a hard pressure a large group of investors act similarly and copy the behavior of others, especially when there is a strong social interaction among market participants. For the last decades the world faced several severe economic and financial crisis due to the fact that market participants were tempted to follow trends and to make their financial decisions based on emotions rather than relevant financial strategies. Regardless of the case we are discussing, either it is tulip mania from 17^th century, the first speculative financial bubble, which was followed by a massive and prolonged crisis in the region, roaring 20^th, which was followed by the great depression, dot-com bubble at the end of 20^th and at the beginning of 21th century, when everybody was investing in web based companies, global financial crisis in 2007-2008, after real estate bubble in the US burst, or recent bitcoin hysteria nobody know how long will last, the reason lays in herd behavior. The illustration bellow represents the summary of the world’s most severe breakdowns.

Source: www.franklintempleton.com

For the past few decades a lot of experiments were conducted and several hypothesis were developed trying to find the correlation between herd behavior and financial decisions. Furthermore, a new scientific field was formed, behavioral finance, part of behavioral economics, which is a new paradigm in our reality with a purpose to observe and study behavior of market participants based on their pure judgment. The main assumption of behavior finance is that individual investment decisions are based not only on the financial market, but on the unique characteristics of market participant and on the information they have. Thus, lots of factors affect individual decisions and herd behavior is one of them.

In 2016 CFA Institute conducted a survey among its readers and associates to determine the leading behavioral bias affecting their investment decisions. 724 practitioners participated in the survey and 34% of them indicated that during decision making process they are influenced by their peers and follow current trends. The diagram bellow represents the complete survey results.

Examples discussed above proves the existence of collective decision in the financial markets. One of the most widespread hypothesis is that herding behavior arise due to information asymmetry.  Information asymmetry is an imbalance between two parties in terms of information and knowledge they have access to, which leads some of market participant to be in a better position. As a result, rest of the agents suffering from information scarcity are tempted to imitate actions of others and to become a part of the herd. To conclude, herd behavior is directly correlated with the information available in the financial markets and with the ability to have access to this information. This explains why developed markets with higher information concentration exhibits low lever of herd behavior, compared to developing markets, where information and quality of this information is not sufficient to make sound financial decisions.

Based on the past experience it is perfectly clear that the society fails to learn from mistakes and repeats the same actions and strategies over and over again. What can we do to avoid becoming a part of public hysteria and to come up with rational financial decisions? If you are planning to invest in something or to trade with financial securities here are some tips you can follow in the first place:

• First and for most having access with full scale of information is very important. Otherwise it will be very challenging for you to come up with rational decisions;
• Try to follow your insticts and do not get influence by your peers;
• Do not invest money in a business you do not understand;
• Create a wide portfolio of your financial assets and securities, diversification this will help you to reduce risks.

Wish you the best of luck and remember:

“If 50 million people say something foolish, it is still foolish”.

William Somerset Maugham

Author: Ana Akopashvili