Blindly following someone can get you into trouble at any time. You may consider investing in certain assets without a second thought if the majority of traders in the market feel that they are better financial instruments to purchase. The same holds for trading.  This form of behavior is recognized as herding behavior.

Humans are herd animals in many ways. We tend to assess and establish opinions based on the norm determined by the herd around us. Herd mentality is one of the most prevalent cognitive biases influencing financial markets. This phenomenon, which stems from people’s tendency to find security in numbers, can significantly impact investment decisions.

Be it a long-term investor or a day trader, purchasing financial instruments solely based on the knowledge and research of another person instead of own independent analysis is risky. So, investors need to be wary of the dangers of herd mentality and not allow it to influence their investment strategy. 

This article will cover herd mentality bias in detail, along with practical strategies to avoid falling into its trap in the realm of trading. 

What is Herd Mentality?

In behavioral finance, herd mentality is a phenomenon where people join groups and prefer following the crowd, bypassing rationality and own information. They behave in a way that supports the group’s ideas, thinking everyone else has already done their analysis. 

It results from a person’s innate need to fit in the crowd, which obscures and impairs their decision-making process. When most of the crowd is moving in one direction, a person who wants to move in the other direction can feel wrong or distressed. Or they can be afraid of being singled out for not following the trend. Because of this, investors tend to follow the crowd and buy assets they think other people are buying, skipping their sense of personal identity. Here, individual principles and ideas are overtaken by herd values.  

Herding behavior is common in all aspects of society, even within financial markets, where investors follow the investment decisions of others without conducting adequate research. Investors can lose money, and it can impede market expansion and economic growth on a big scale.

Herd mentality bias at scale can form asset bubbles, or market collapses through panic selling and buying. In the stock market, herding is infamous for being the reason behind big rallies and sell-offs. An example occurred during the recent dot-com bubble when investors bought stock in numerous internet-based companies following the crowd, expecting to make large profits but never did, which led to a dramatic sell-off.

 Understanding Herd Mentality

Herd mentality is a behavior in which people react to the activities of others and follow their lead. This is similar to the herd behavior observed in animals when they charge in unison to avoid perceived or actual danger. All of the animals begin to swarm after one another. Herd mentality is characterized by a lack of personal reflection or decision-making, and a tendency to wait for the action that others take. 

Herding behavior originates from the emotional aspect of the human psyche instead of rational thinking. Even in this day of globalization, it is not unusual to witness people grow an inclination to behave in the same manner as the majority of their peers. They are prone to this bias in several ways, from the way they shop to the way they invest.

An informational cascade occurs when people rely on the opinions or decisions of others instead of their independent analysis. Here, individual ideals and values are superseded by the values of the group. Decisions are reached by consensus that goes beyond each person’s self-identity. For example, investors may follow suit if they observe others buying a certain asset and assume those investors have greater information. These informational cascades can result in herding behavior and create market inefficiencies.

Furthermore, many people believe the illogical notion that a large number of people involved in a decision or action hold a lesser chance of being wrong. Once more, this is a human instinct. Anyone who lacks experience or in-depth knowledge in the field should refrain from openly opposing the majority.

Mob or herd mentality is not always a bad thing; political alliances and protests have helped many nations experience freedom. But because it stifles personal opinions, it is regarded as a harmful idea. People behave in a conforming manner due to fear of being left out. 

 Signs of Herding Behavior

While individuals have an innate need to be a part of a community, some characteristics make them more prone to herd mentality bias. These are:

• Aversion to Conflict: People who prefer avoiding conflicts tend to opt for herd behavior rather than speaking up or defying the consensus. 
• Aversion to Risks: Those who lack the confidence to take a chance would much rather stick with the status quo, even when the risk is calculated and shown to be well worth the shot.
• Lack of Self-Awareness: Some people would rather adopt predetermined roles or identities instead of working toward self-knowledge and developing positive self-esteem.
• Innate Laziness: People with herd mentality opt to continue their “relatable” hardships rather than take on the challenges of making difficult decisions that could enhance their lives. People need to constantly focus on developing their time management skills to overcome innate laziness and become more productive. 

Herding Behavior Examples

Restaurant Choices

A busy restaurant usually means better food than the less busy, open-table restaurant next door. Here, we don’t think the crowded restaurant would employ seat fillers to beat the rivals. We succumb to the illusion of crowdedness – the herd’s decision – instead of judging the food quality. 

It is interesting to note how we are hard-wired to herd. Many consumers will make decisions based on the decision of other people when choosing a restaurant. 

Investing in the Stock Market

For example, an investor searches for information on the internet for investing in the stock of the healthcare industry. He concluded from his research that these companies continuously provided a reasonable rate of return and that there has always been an increasing demand for healthcare. However, the news was replete with images of the rapidly expanding IT industry, and a well-known mobile application developer was in the spotlight due to a recently developed technology.

People were swayed by the information, and the investor chose to invest in IT instead since he wanted to make money and the rate of return sounded decent. He made that decision without any fundamental analysis or market research and because his investor colleagues had invested in it

These instances of herd bias encourage investors to do their homework, exercise critical thought before making investment decisions, and avoid just following the crowd without question.

Herd Mentality in Trading 

A trader’s thoughts influence their actions in the trading market. Fear of missing out on a great stock is a prevalent psychological trait among novice or inexperienced investors.

Investors with poor decision-making skills would rather rely on the opinions and analysis of other investors. As a result, many investors buy that same stock since they follow the crowd in the trading market. In other words, trade fear among investors is what causes herding behavior. 

When it comes to day trading, investors typically have less time to reflect because of their intense fear of missing out on a worthwhile investment. So, day traders are more prone to herd bias. A trader may decline a worthwhile venture just because other traders disapprove of it.

Trading performance in the market can be enhanced by traders if they choose to suppress their herding behavior. When you understand how to avoid following the crowd and make informed decisions after conducting thorough research and your own analysis, investing in the trading market is always secure and fulfilling.

How to Avoid Herding Behavior while Trading?

Following the crowd movement without conducting your own analysis may end up in a great loss. The following strategies can give you the best safeguard against the herding behavior of investors and traders.

Research Thoroughly

Comprehensive research is the foundation of a sound investment decision. Consider the asset’s fundamentals, market movements, and risks carefully before making any investments. The independent analysis protects against the impact of herd mentality bias. 

Establish Clear Investment Goals 

Defining clear investment goals plays a crucial role in avoiding herding behavior. Volatility is present in the markets. Even bull markets have experienced panic selling moments. Being aware of your financial goals, time horizon, and risk tolerance will help you form decisions based on your individual needs instead of giving in to the stress of collective market behavior. 

Diversification of Portfolio 

One effective trading strategy to lessen the effects of herding bias is portfolio diversification. You can lower your risk of being unduly exposed to market sentiment variations by diversifying your investments among a variety of asset classes, industries, and geographical areas.

Stay Aware but Be Skeptical 

While keeping up with market trends is vital, it’s also critical to approach information with a fair dosage of skepticism. Don’t be influenced only by the actions of the majority; instead, consider the reasoning behind popular trends. Critical thinking is an ally of an investor to navigate the intricate world of financial markets.

Follow your Plan

A thoroughly designed plan based on long-term investment objectives is necessary to resist the pull of herding behavior. Stay true to it once you have established a strategy based on your risk tolerance and goals. Refrain from acting rashly in reaction to transient market swings or the behavior of the crowd.

Contrarian Strategy

Another way is to use a contrarian strategy which involves buying while others are panicked, purchasing assets when they are cheap, and selling when excitement gives way to bubbles.

How Traders Can Use Herding Behavior to Their Advantage?

There are certain advantages to herding behavior. It enables inexperienced or ignorant investors to profit from other people’s research and due diligence. For example, passive index investing is a herding technique that focuses on simply mimicking the performance of the whole market.

Herd mentality can also cause a new trader to exit their position early because it’s frequently preferable to sell with the herd than take the risk of becoming a bag holder.

Conclusion

Herd mentality is the tendency to believe that a course of action is right because many people are doing it. This form of behavior is linked to the innate human need to fit in, yet it frequently has unfavorable effects. In trading, this can take the form of financial bubbles or panic buying.  

Although traders may be able to take advantage of herd bias, they should also make sure they are aware of it and know how to avoid it. Examine and match your social requirements to your objectives and principles rather than just following the crowd. Besides, adopt a contrarian approach and avoid making decisions under stress.