Herd Mentality Bias

Human beings are social animals. For centuries, our brains have been wired to conform to the actions of the larger group. This is because, in the old times, a person’s probability of survival would be negatively impacted if they were not in a group. This herding mentality may have helped our forefathers survive in the wilderness. However, when it comes to financial markets, its utility is limited.

In this article, we will have a closer look at what the herd mentality bias is and how it negatively impacts the interests of investors in the stock market.

What is Herd Mentality Bias?

Herd behavior can be defined as the tendency to confirm the actions of the larger group. This tendency to conform may be caused by a lot of reasons, which will be discussed later. However, the final outcome of the herd behavior mentality is that a large number of people act in the same manner at the same time. In the stock markets, herd mentality manifests in the form of volatility. The prices suddenly increase or decrease because a large number of people try to enter or exit the market at the same time.

There are several motivations that cause herding behavior. The most obvious one is the lack of information. In many developing markets, investors are aware of the fact that information is often distributed in an asymmetrical manner.

Hence, there is always a possibility that someone with better information than them is trading. This lack of information creates a lack of confidence amongst investors, which indirectly creates a herding effect. There are other explanations for herding behavior as well.

A lot of these explanations do not assume the investor to be a rational agent. For instance, herding behavior may be the result of speculative activity. Since the investor has no idea about what the intrinsic value of the stock is, they just try to time the market. This results in herd behavior as well. In some cases, herd behavior is simply the result of pressure to conform, which is also known as peer pressure.

When it comes to institutional investors, they too want to confirm with the herd. This is because the personal reputation of the fund manager is often on the line. They do not want to be seen as someone who did something risky or reckless and lost money in the process. This is the reason that they prefer to fail conventionally rather than succeeding unconventionally.

Types of Herding

Herd mentality bias has been an important topic of discussion in the financial circles. This is the reason that a lot of literature has been generated on the topic. This is also the reason that we now know that not all types of herd behavior are the same. The differences in herd behavior have been written below.

Herding can be efficient or inefficient. In the case of efficient herding, all investors arrive at the same decision. However, that same decision is also the right decision from a mathematical valuation point of view. Hence, such herding is encouraged and even forms a part of the efficient market hypothesis.

On the other hand, we have an inefficient herding. Inefficient herding is when a lot of investors agree on a decision. However, in hindsight, the decision appears to be incorrect or even absurd. This type of herding is responsible for financial disasters.

How Herding Affects Investor Behavior?

There is no other behavioral bias that has caused as much loss to investors worldwide as herd mentality bias has. In this article, we will explain how herding impacts decisions.

  • Creates Bubbles: The end result of herd mentality is an asset bubble. An asset bubble is nothing but the propagation of a false trend by the entire market. The problem with herd mentality is that no one is checking the facts for themselves. Instead, everyone is assuming that the entire group knows the facts. The meteoric rise in prices and the catastrophic drop are not possible as long as the crowd does not behave irrationally because of herd mentality.

  • Creates Volatility: Most of the time, herds do not keep on making irrational decisions till their actions are completely out of sync with reality. In most cases, irrational decisions are corrected sooner. However, the market sees a series of over and under reactions spread over a time frame. This herd mentality is the reason that volatility is created in the asset markets. Ironically, this volatility is what reinforces the herd behavior. The herd behavior becomes like a self-fulfilling prophecy.

How Can Herding be Avoided?

Successful investors have not become successful by following the herd. Instead, they have become successful by exploiting the gaps that are created as a result of herd mentality. The underlying theory of value investing is that one should be vigilant for stocks that become underpriced as a result of the herd mentality!

Investors ought to make rational decisions based on facts instead of making emotional decisions based on a desire to confirm. A lot of investors prefer to invest passively to avoid herd mentality. They maintain distance between themselves and the market since it helps them maintain their calm and make rational decisions.

The bottom line is that the herd mentality bias is really the worst amongst all types of behavioral biases. Investors need to manage this bias, or else it could have a serious negative impact on their net worth.

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