Updated: Jan 12
Yes, herding doesn't just apply when rounding up animals...it's used in finance as well.
How Big of a Role Does Herding Play in the Stock Market?
A very big one. In fact, herd instinct is extremely common in the stock market. You may even be guilty of it too.
It is notorious for being the cause of rallies and sell-offs. This theory states that people will mimic what they see others doing because the general assumption is that a large group of people cannot be wrong. So for investors, if they witness a majority of their peers and colleagues buying the same shares, chances are they will to. One is that they are guided by fear of missing out (FOMO) on a profitable investment, provoking them to invest. But this can also lead to late entry timing. Nonetheless, this herd behavior or information cascade can cause great financial harm in the long-run if one, the initial source makes an erroneous decision or if two, conditions change.
How Does Herding Affect the Overall Industry?
This can lead to either a growth or decline in an industry, which are commonly referred to as investment bubbles; solely because of initial support due to speculation.
This exact lack of a strong foundation is what causes market rallies and sell-offs that are unfounded. Market behavior drives a rapid escalation in the price of an asset beyond its intrinsic value, causing an inflated price. Due to the inflated price, individuals will no longer be willing to buy the asset and as a result of decreased demand, prices will drop. This dip results in a large sell-off which inevitably leads to the collapse of an industry.
Bear and Bull Markets
Individuals will exhibit different accounts herding behavior during bear and bull markets. During bear markets, investors will engage into short-selling, a risky investment that offers large rewards if done correctly but vast losses if done wrong.
However, during bull markets, many investors will choose the classic method of buying and holding. Those who like to take risks will engage in full-swing trading and high frequency-trading.
Wanna know more about behaviorism and how to avoid its traps? Click here.