How to avoid the herd instinct when trading
The bandwagon effect can cause major disruptions to trading, causing prices to rocket before they crash back down to earth
Chances are you are all too familiar with the herd instinct. Whether it’s a water cooler moment when you realise you’re the only one not watching the latest Netflix series (and then binge watch the whole thing in two nights) or eating the latest fad food (it’s vegan ‘meat’ if you’re wondering) – we are all guilty of following the crowd.
What is herd instinct?
This bandwagon effect also comes into play because we believe the consensus. If everyone says something is great, they must be on to something. Right? It’s why TripAdvisor is such a massive success. Most of us will pick a restaurant with the most positive reviews. Similarly, we would pick a busy restaurant over an empty one. We make our decisions based on the decisions of others.
Following the herd is a primitive defence mechanism. Cavemen were more likely to survive when they hunted as a herd and shared the spoils. That same urge to stay safe and stick with the crowd affects us all today – even if we’re not fighting for survival, although it can sometimes feel like that on the trading floor.
Herd behaviour in financial markets causes widespread investing in particular markets or individual stocks or shares, based almost solely on the fact that the majority of traders are buying them. It’s all about FOMO – the fear of missing out on a profitable investment that is often the driving force.
According to a survey by the CFA Institute, herding is the topmost bias affecting investment decision making. And this bandwagon effect can be catastrophic, causing prices to rocket, before they crash back down to earth.
Herd behaviour and investment bubbles
An investment bubble happens when the price of an asset is driven by the over-exuberant behaviour of investors, rather than the intrinsic value of the asset itself. When there are no more investors willing to pay the over-inflated price, people panic, sell, and the bubble bursts.
Herd instinct is one of the main causes of investment bubbles. A growing number of investors back a specific stock, causing the price to rapidly rise. This then attracts the interest of more investors, who assume the herd must be right because of the surge in value.
One example of this type of bias affecting the market was the dotcom bubble in the late 1990s. Venture capitalists were looking for the next Facebook or Amazon and threw money at a variety of internet start-ups in the hope that they would become profitable. Herding instincts kicked in as investors were desperate for a piece of the next big IPO, ignoring the fundamental rules of investing in the stock market, such as analysing price-to-earnings ratio, studying market trends and reviewing business plans.
At the peak of the dotcom bubble, the herd effect was at its most fervent. The Techmark index – newly formed to track the growing mass of technology and internet stocks in November 1999 – started at 2,421. By March 2000 it had grown to 5,753.
The herd effect also saw record amounts of capital flow into the Nasdaq, with its index rocketing from under 1,000 to more than 5,000 between 1995 and 2000. By 1999, 39 per cent of all venture capital investments were going to internet companies.
Around that time several major hi-tech companies, such as Dell and Cisco, placed huge sell orders on their stocks, causing investors to panic sell. In addition, investment capital began to dry up, which left cash-strapped dotcom companies without essential funding.
By the end of 2001, the majority of publicly traded dotcom companies folded, the Nasdaq dropped by almost 77 per cent and trillions of dollars of investment capital were lost in the ether.
The trouble is, just as the clarion call of the herd was at its loudest, the top of the market had already been reached. And this is the major flaw of herd behaviour.
The pursuit of money, with no plan of how to achieve your goal other than blindly following others, is destined for failure – or, at best, modest success.
How to recognise herd instinct
Herding behaviour in stock markets is particularly common among novice traders, who often follow trends because they don’t have the confidence or experience to make their own decisions. However, it can affect the all traders, of all abilities.
Examples of herd instinct
- Making decisions based solely on the actions of other traders, foregoing your own private information
- Reacting to commonly known public information and making similar investment decisions
- Jumping ship due to negative news coverage, or a sell-off, without studying the market
- Exuberant trading causing an investment bubble, due to fear of being left behind, while ignoring the fundamentals of investing.
How to avoid herd instinct
Watch trends, analyse the charts and keep an eye on market movements. By doing so, you’ll see the real patterns and market movements behind the trends and be less likely to fall victim to herd behaviour.
Remember, while following trends blindly is never a good idea sometimes the herd will make smart decisions, so don’t blindly ignore them, either.
Do your research and invest in stocks that your analysis suggests will generate the best rate of return.
According to financial psychiatrist Kim Stephenson there is no right or wrong answer when it comes to investing, as everyone is different, with different demands and needs. This is why following the crowd is never a good idea.
You should decide what return you need and the best way of achieving it. Ask yourself:
- How much do you need?
- When do you want your money?
- How safe do you want it?
- What’s the required rate of return?
FURTHER READING: Behavioural finance: how your biases affect trading
FURTHER READING: Over-confidence bias: the downfall of many traders