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Herd Behavior and Investment in Financial Markets

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

This lesson explains why humans are prone to herd behavior in financial markets by discussing a few human biases like social proof and incentive-caused bias. You'll also learn about steps you can take prevent being 'swept' away by a group.

Herd Behavior

Don't be a lemming! You've probably heard that phrase before. But where does it come from, what does it mean, and what the heck is a lemming? Well, the phrase basically means that you shouldn't do something just because other people are doing it. In other words, think for yourself!

Lemmings are furry rodents that inhabit predominately cold places. In the 1950s, a few documentaries alleged that lemmings commit 'mass suicide.' Footage at the time, which was later found to have been staged, showed lemmings, jumping off a cliff one-by-one. Each lemming followed the one right before it, seemingly unfazed or unaware of its grisly fate. So while it's not true that lemmings commit mass suicide, the characterization stuck. Voila - 'Don't be a lemming.'

In some respects, humans are no better than the fictional cliff-jumping lemmings. We are social creatures, and we seek the approval of those around us. This often leads to herd behavior. We start to let the collective, the group, think and act for us. When that happens, we become no better than the marching lemmings. In this lesson, we'll explore the reasons why we get swept away with herd behavior. We'll examine a few human biases (you can think of these biases as faulty wiring that makes us systematically make mistakes). We'll describe how these biases lead to herd behavior amongst investors and in the finance industry. We'll then end the lesson by discussing what we can do to protect us from this behavior.

Social Proof

The first human bias we will discuss is social proof. This relates to the human tendency to conform to the will of a group. If you've ever felt peer-pressured to do something, you've been exposed to social proof. We see it manifest often during recess on the elementary playground. 'Eat the bug. Eat the bug… everyone does it,' shouts the crowd. We see it in the stock market. During the late 1990s, millions of Americans bought technology stocks. Eventually the momentum became so great, that a lot of investors bought the same stocks. The stock market became a cruise ship. As everyone moved to one side of the ship, the whole thing became imbalanced and a correction became inevitable. We often go along with the group because we want to feel included. We want to be liked.

Cognitive Ease

Another reason we tend to go with the crowd is because of cognitive ease. In other words, it's easier to do that than to think for ourselves. Thinking is tiring. Concentrated effort is tiring. In herd behavior, you 'outsource' the thinking to the group, and your brain can take a vacation. If the situation is stressful and you lack knowledge, then the tendency to give yourself to herd behavior becomes even more intoxicating. For example, imagine you are in a department store on Christmas Eve, and you need to pick out a gift for your 4-year old daughter. You really have no idea what to get her, but you need to make a decision within the next 10 minutes. Chances are you'll just gravitate to the gift that everyone else is running, screaming and clawing for. 'If they like it, it must be good' you reason to yourself. If you do not want to think, you'll let the group do the thinking for you.

Today, the latest investment craze is passive investing. This refers to the approach where investors systematically invest in low-cost index funds. The approach is systematic because the common approach is to continue to invest the same amount every week, month or year without regard for the market's valuation. Index fund investing has considerable advantages over active management (including lower cost, good performance, low transaction fees, etc.), but this type of behavior, when taken to an extreme, can cause ill effects. If everyone in the marketplace does not think, and instead systemically buys index funds then the market will get distorted. Even bad companies may report strong stock returns. It's like the adage, 'a rising tide lifts all ships.'

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