What is Herding Behavior in Stock Market?
Herding behaviour in the stock market is when investors make decisions based on other investors’ investments. Other names for this behavior include herd mentality and herd instinct. Herding behavior explains investors’ tendency to imitate or follow what other investors are doing. Usually, they believe that what other investors are doing will be profitable without any analysis.
Herding behaviour in the stock market occurs due to several factors. These may include investors’ emotions or their instinct. Without carrying any independent analysis of their own, investors may prefer imitating other investors, expecting to succeed. This phenomenon stems from behavioural finance, where it can lead to herd bias.
Herding behaviour bias (or simply, herd bias) is when investors base their decisions on other investors’ investments. It is a naturally occurring behaviour in humans in all fields. Herding behaviour bias leads to investment bubbles, such as the one created by Bitcoin recently. In short, herding behaviour is the tendency of individuals to confirm the actions of a larger group.
How does the Herding Behavior impact investors?
Investors involved in herding behaviour may experience losses. According to a report, herding bias is the highest loss-making behavioural bias for investors. Therefore, it places herding on the top of any investor’s avoidance list. The herding behaviour can impact investors in one of two ways. It either exposes investors to volatility or creates a bubble in the market.
Firstly, the herding mentality can cause a series of over- or under-reactions in the market. Due to the large extent of these reactions, the market suffers from volatility. On the other hand, it also creates an asset bubble. Usually, everyone in the herd assumes their decisions are rational. This herd action creates a sudden rise in the asset’s price and also causes it to fall in the future. This way, it causes investors to suffer from the creation of volatility and bubbles.
Why do people suffer from Herding Behavior Bias?
The primary reason why individuals or investors become a part of a herd is because of their nature. Humans have long been part of the groups to survive and evolve. Similarly, humans are social animals which tempts them to be a part of the group. Therefore, their instincts entice them to follow what others are doing.
Another reason for the herding behaviour is the lack of information. When investors don’t analyze information on their own, they become dependent on others’ decisions. Once they become a part of a group, they assume the herd has accurate knowledge to manage their investments. In most cases, the opposite applies.
How to avoid Herding Behavior?
In theory, it is straightforward to avoid herding behaviour. By not following what others are doing, investors can easily avoid the effects of herding behaviour. In practice, however, it is not as easy. The best way to protect against herding behaviour is to understand how it works. For example, when buying a company’s stock, investors can look at how the market perceives it.
Avoiding herding behaviour does not mean that investors must not invest in securities where others are investing. Instead, they must perform an independent analysis of any investment they make. This way, they can ensure they don’t become a part of a herd. Even if they do, they will realize when they should leave it and not suffer losses.
Herding behaviour in the stock market occurs when investors base their decisions on what others are doing. Usually, they don’t collect any information and assume the herd has accurate information regarding investments. It leads to herding behaviour bias and can cause bubbles and volatility to create. Despite that, herding behaviour is easily avoidable.