At some point in our lives, we have all likely been part of a herd. Some people may prefer to always be part of a herd, rather than standing out or being different. This mentality is developed because throughout their lives, they are often taught to conform to societal norms, follow rules, and behave in a way that is acceptable to others.
As a result, they may become accustomed to living in this manner and may lose the habit of thinking for themselves. Over time, this can lead to the development of herd mentality, where they simply mimic the actions and beliefs of others without critically examining them.
Herd Mentality for survival?
In the past, when humans were nomadic, it was necessary to belong to a society in order to survive. This mentality of conformity has been passed down through the generations, even though circumstances have changed. Today, this mentality of following the herd can still be observed in areas of life that do not necessarily require it, such as fashion craze or diet craze. For example, consider the trend of people following the keto diet, which involves eliminating carbs completely. Many people may have adopted this diet without thoroughly considering whether they would be able to stick to it strictly. As a result, they may not have followed the diet correctly and instead of losing weight, they may have gained weight over the course of their diet.
Herding bias in investing:
In investing, as in other areas of life, people often follow the herd. Herding behaviour is clearly evident in the buying of shares of a company, where people tend to follow those who are making money in the hope of replicating their success by copying their actions. This may be due to a lack of knowledge about investing, leading people to rely on the knowledge and decisions of others rather than studying companies and making their own independent decisions. Another factor that may contribute to this behaviour is the fear of missing out (FOMO), where people worry that the stock price will increase and they will miss out on the opportunity to earn a profit.
Effects of herding bias:
Herding bias can lead to creation of bubbles and volatility in the markets. When a large number of people make the same investment based on the actions or recommendations of others, it can drive up the price of the investment and create an artificial demand. This can result in a bubble, or a situation where the price of an asset becomes inflated beyond its intrinsic value. For example, consider the dot-com bubble of the late 1990s in the USA. During this time, the prices of technology stocks or those having tech or .com in their name surged irrespective of whether they were generating any business or not. This led to creation of a bubble which was fueled by herd mentality bias.
An example of increased volatility in the stock market occurred during the period from March to June 2020. At the start of the COVID-19 pandemic, stocks of all companies saw a sharp decline. As people were still trying to understand the effects of the COVID-19 pandemic on businesses and fearful of the uncertainty caused by the pandemic, they followed the herd and first sold their holdings. This led to a sharp drop in the prices of all company shares and increased overall market volatility.
How to stop herding:
Warren Buffet has aptly advised investors to be “fearful when others are greedy, and greedy when others are fearful”. This advice highlights the importance of not following the herd and making your own decisions. By being aware of the tendency towards herding and being alert to it, you can stop yourself from herding. This would require making an effort to think independently and critically evaluate decisions, rather than blindly following the actions or recommendations of others. It can also involve seeking out diverse sources of information and being open to alternative perspectives.
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