Behind Finance: Herd Mentality in Trading
By - Dan Raju, CEO at Tradier on
Jul 27, 2021 at 1:50:29 PM
How often do you make trading decisions based largely on the hype of what other people are doing? Even experienced traders are susceptible to following the crowd more than logic at times. In the trading world, this is described as herd mentality. It is often difficult to ignore exciting, over-hyped trends, especially in a volatile market. Nonetheless, separating your logical trading decisions from your emotions is crucial to a strong trading strategy. Read on to learn how herd mentality affects both your decisions and the overall market—and how you can build resilience into your trading style.
What is Herd Mentality?
The term herd mentality refers to the tendency of people to follow what others in their group are doing, especially in response to an inciting factor like a threat or surprise. Herd mentality is a survival instinct and it isn’t always a bad one. Sometimes it helps us make productive decisions on the fly. For example, if you’re driving and notice that all the cars ahead of you are merging into another lane due to a traffic accident up ahead, most likely you will do the same and avoid having to do it at the last possible minute—aka, when you come up right on the accident and have no choice but to change lanes.
You followed herd mentality to make that decision by assuming that the cars ahead of you knew what they were doing. In this case they were right, so you were right. The “herd” doesn’t always know what they are doing, however. In fact, most people in situations driven by herd mentality aren’t acting based on their own knowledge or experience at all. Instead, they’re choosing what other people are choosing simply because others are choosing to do it.
How Herd Instinct Affects You as a Trader
Herd mentality is often strong enough to convince you that your own perceptions are flawed and that others know the way. Because of this, trends and hype can do more to validate your decisions than experience or thorough analysis.
The financial market involves so much risk, uncertainty, and change that it is a prime opportunity for herd mentality to thrive. While paying attention to trends and data is a necessary part of any successful trader’s strategy, herd mentality favors the trend above all else. For example, when more people start selling their shares, others assume they have a good reason to do so. This puts pressure on them to sell as well. Like a stampede, the number of people following the herd quickly multiplies—and then you have a case of panic selling.
How Herd Mentality Influences the Market
The problem with a stampede is that it can cause more harm than the original threat. Indeed, the danger may not even be real. We've seen this happen in the financial market many times. A news report of low company earnings, a failed product, or a lawsuit can trigger worries that the stock value will fall. The rumor mill starts turning, and some traders decide to sell. Before long, there is an enormous sell-off and people are left with losses they could have avoided if they had held their shares.
A market bubble is another result of herd mentality. Because people are eager to imitate group actions that seem beneficial, they'll hop onto the bandwagon for rising stocks. The dotcom bubble is a perfect example of this. Traders in the late 1990s were irrationally excited about newly public Internet companies. As more and more investors bought shares, the stock values skyrocketed beyond the actual earnings of those companies. Once the capital dried up, the bubble burst, and investors were left with massive losses.
Historic Herd Mentality Effects on the Market
One historic example of how herd instinct leads to bubbles is Tulipmania, which happened in 17th-century Holland. Tulips were a rare and highly valued commodity at this time. Wealthy merchants who wanted to prove their clout began purchasing tulips in insane numbers. This drove up the flowers' price to exceed even the cost of some houses! Tulip investors hoarded their wares in hopes of amassing wealth. Of course, the upward trend did not last, and tulip prices dropped to normal levels within a week leaving the investors at a significant loss.
A more recent example is the GameStop (GME) short squeeze. In January 2021, members of the subreddit r/WallStreetBets purchased shares of GME stock, contributing to an artificial raise in the price of GME stock. Their outcome disrupted hedge fund investors who were betting on a downward trend. This would have led to sizable profits once the value plummeted, but individual investors一most likely following herd mentality一created a GME bubble and shifted the market significantly. Unfortunately, the trend drew a lot of investors to pour money into the stock, only to lose it when the bubble finally popped.
Panic sell-offs and overconfident investment bubbles have happened for centuries and will continue to happen. They are a major side effect of herd instinct in trading. In 2021, cryptocurrency markets are deeply affected by herd behavior. Between fall 2020 and spring 2021, Bitcoin's value grew 600%, but then plummeted by early summer. Crypto is an emerging and volatile market, which makes it extremely difficult to predict. So, many investors follow the crowd, which creates bubbles that pop quickly.
Conclusion: Always Do Your Own Research
The best way to avoid the negative effects of bubbles and sell-offs is to do your due diligence. When others start buying a trendy new stock or selling out of fear, think before making a transaction. Review the data. And always do your research before attempting to short-sell a stock or join in a buying craze.
Individual decision-making is always more advisable than the herd mentality. Set aside your concerns about missing out on a hot new stock. With clear investment goals, you can trade with greater clarity and confidence — and not fall sway to panic buying or selling.