As a collective, we are social beings. Oftentimes, this means we are influenced by the opinions and decisions of others. When we make decisions based on what others believe or do, we are falling into herd instinct or herding. The concept, “if everyone is doing it, it must be a good thing” is how so many of us go with the crowd and make choices we perceive as the best, safe or good. Some common herding examples are selecting a restaurant based on its positive reviews or making investments based on other investors’ without analyzing our options for ourselves.
Herd Instinct
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What Is Herd Instinct?
Common Herding Behavior
Herd instinct is a natural occurrence that is found in all aspects of society but it isn’t always a good thing. Herding can hinder our decision making and end up costing us opportunities.
Herd instinct is where we follow the decisions and opinions of others because we believe it reduces risk.
In finance, herding happens when investors take the crowd's advice rather than undertaking their own analysis.
Herd instinct can be avoided by taking a step back, conducting personal research and rationalizing a situation.
Why Do People Follow the Crowd?
Humans are social creatures and because of this, we are easily affected by others. We tend to fall into herd instinct and seek acceptance and inclusion from others who hold the same views and values as we do to shape our beliefs and decisions.
In general, following the crowd is also far simpler, which is why so many of us do it. After all, it’s difficult to make informed decisions by gathering pertinent information on all interesting products and services. It’s far easier to follow others’ decisions, especially if you believe they have done their research or know best. While this can help in the case of buying a product or getting a service, this mindset is not ideal when it comes to big life decisions, such as your career path or your finances.
Understanding Herd Instinct
Herd instinct or herd behavior is defined by a lack of independent decision-making, causing one to think and behave similarly to everyone else. This can manifest in what we buy or how we think and is present in many parts of our lives, such as choosing services, food options, purchasing products and investing our money.
To clarify, herd instinct in finance happens when investors follow in the footsteps of others. By doing so, they are being influenced by emotion and instinct instead of relying on their own independent analysis, which is an essential step before investing in any product.
Herd instinct and influence is all around us. The following are some common examples of where herding can show up in our everyday lives.
Herd Instinct Example: Choosing Where to Eat
Even the simplest decisions, such as where to eat or what to order, can be influenced by herd instinct. Imagine you’re out for the evening with your friends, you’re hungry and have two restaurants nearby. The first one has a crowd lined up around the corner and the other one barely has any patrons. If you were following the herd instinct, you may end up choosing the one with a crowd because you presume it likely has better food and is popular for a reason.
Key Takeaway
Rash decisions like choosing a restaurant based on the crowd can be harmful, even on a small scale. For instance, you may end up spending more per dish at the restaurant than you intended and justify it because the restaurant is popular. In turn, your choice may have you going over your spending budget.
Herd Instinct Example: Avoiding the Fear of Missing Out (FOMO)
The fear of missing out (FOMO) can easily cause us to make hasty decisions. For example, a subset of traders drove up the price of Bed Bath & Beyond’s stocks by more than 60%. This happened in line with the rise of “meme stocks,” which are stocks that have a following from online communities and rise and fall based on their narratives and conversations.
Key Takeaway
Bed Bath & Beyond and its stock increase demonstrate how herd behavior and overconfidence can impact the market. The rise in price didn’t occur because the company made strong financial moves. Rather, it rose due to retail trader interest and their fear of missing out (FOMO) on trends. In reality, good investment decisions should be made based on ample research on the company.
The graph below shows how Bed Bath & Beyond's stocks spiked in June 2021 compared to the rest of the year.
Herd Instinct Example: Making Purchases
Everyday purchases are also affected by herding. We may end up buying a popular product we see online simply because it’s trending, but later discover it’s not that great or that it doesn’t really fit our needs or lifestyle. For instance, if you’re shopping for a particular type of sunscreen but haven’t done your research, you may gravitate towards popular name brands you recognize.
Key Takeaway
In the long run, basing your decisions on what others buy can impact your pocketbook, provide you with an item that doesn’t match your needs and result in you having to buy another product because you didn’t do your research prior to shopping.
For instance, reviews and star ratings can influence people's purchasing decisions. The more stars an item has, the more you are likely to think the product is exceptional, which may not be the case. Stars ratings and reviews are examples of herd instinct.
Another example would be how we view a company or brand online. In a 2013 study, having a prior positive and negative social influence affects the way we rate the company or brand. The study concluded that when the initial rating is a positive one, there is a 25% chance that the ratings after would also be positive.
Herd Instinct Example: Buying Stocks
First time investors can be easily influenced by the herd instinct and make poor financial decisions. For example, they may end up buying certain stocks or selling them based on societal influences and market chatter.
Key Takeaway
For instance, if you learn some of your coworkers are making gains from a certain stock or cryptocurrency, you may end up buying the same in order to reap the same benefits. However, without proper research, you can’t guarantee the same benefits and may end up buying at a price that’s too high, which can ultimately result in losses.
How to Escape Herd Instinct
Blindly giving into the herd mentality bias can be damaging for your finances. While it is challenging to curb your impulse to join the crowd, there are steps you can take to avoid following the herd.
- 1
Learn to identify herd behavior
When you understand the concept of herd instinct, it can be easier to identify when it’s occurring. Remember, the herd doesn’t know something you don’t; rather, the herd trusts the popular opinion as the most optimal choice, and some may be simply afraid of missing out.
- 2
Know that you have options
Try not to take things at face value. By doing your research, you can better understand the choices you have.
- 3
Don’t factor in the crowd
It’s easy to get caught up in the crowd’s opinions and choices. It’s also worth noting that the crowd does make some wise choices. However, it’s better to remove outside influence from your purchasing decisions. This way, you’re using logic, reason and value of your needs to drive choice versus those of others.
- 4
Evaluate your decisions rationally
Stress, fear and emotions can impact you from rational decision making. If others are rushing to do or buy a certain thing, don’t follow them. Take a step back and examine the merits and drawbacks of the situation.
- 5
Stick to a budget
Determine how much money to set aside per paycheck for savings and other necessities by creating and sticking to a budget. This can help you be more mindful of your purchases and avoid overspending or splurging situations that herd mentality can create.
Herding Behavior and Investment Decision
When it comes to investing, friends, neighbors and acquaintances can easily sway purchasing decisions. Imagine some of your friends invested in a stock that is continuously increasing in value and you haven’t yet taken the leap to invest, too. They poke fun at you for not jumping on this amazing opportunity and pressure you to act on investing quickly. You end up buying the stock because of their comments and influence and hope you’ll be as successful as they have been by reaping the same benefits. While this may work out on occasion, this strategy is not fruitful for an investor in the long run.
The herd effect or following the crowd can lead to trends amplifying beyond the fundamental rules of trading. People can drive up prices when they pile into investments because of FOMO or because they heard something positive but have not done their own due diligence to investigate its validity. As a result, this irrational exuberance is an unstable asset bubble that ultimately bursts causing prices to drop and not rise again, possibly ever.
5 RULES FOR AVOIDING HERDING IN INVESTING
While there can be some benefits to herding, such as passive index investing that follows a herd-type strategy, it’s best for inexperienced traders to avoid it altogether. Prior to investing, review the tips below to avoid falling prey to the herd mentality.
- Keep your financial goals in mind. While risky investments initially seem like a potential jackpot, remember that you’re more likely to lose your money than to gain from it. If this doesn’t support your future goals or can hinder them, then it’s best to avoid that investment. Hold yourself accountable with your money and live with financial intention.
- Do your research. The herd mentality keeps you from doing your own research, which is essential before you invest funds into any product. Make a conscious effort to form your own opinion through research and understanding of the investment you’re about to make.
- Go at it alone. It can be nerve-wracking to invest in something when no one else you know is doing it. However, to avoid the herd instinct, you need to be okay with investing in new things, especially if your research shows it may be a wise investment.
- Consult a professional. If you’re new to the market and you need some guidance, look into finding a professional advisor. Gaining professional input on your research, analysis and preferences can help you determine if a particular investment is a good option for you.
- Take your time. Don’t rush into a market purely because others are. Remember that investing wisely is one of the key ways to start saving money and reach your goals. This should be the driving force behind your investment decisions.
Herd Instinct FAQs
Want to know if there are positive effects to herding, if it’s rational or how it may impact financial markets? Find out more about herd instinct in the commonly asked questions below.
What are the dangers of herd mentality?
Herd mentality bias can lead you to make emotional decisions related to money and other aspects of your life, especially if you’re following trends and others’ opinions without ration or reason. For instance, you can end up spending more than you intend on mediocre quality goods or services simply because it’s a trend you saw on social media. Or, you end up investing in a losing stock or financial investment just because everyone else is.
Is herding rational or irrational?
The herd instinct is, in itself, an emotional bias. It’s not necessarily rational or irrational. It is based on the premise that an individual makes decisions according to what others do, rather than their own knowledge or research.
What are the positive effects of herd behavior?
In some cases, herding behavior is beneficial. For example, a novice or uninformed investor can benefit from others' due diligence and research. A novice trader can also take advantage of the herd instinct to cut losses early since it is often in their best interest to sell with the crowd rather than risk holding on for too long. Additionally, some herding behaviors can be truthful and shed insight on products and services you may be interested in. It’s important to analyze your own needs and wants, but using the opinions of others can be a helpful viewpoint in your research.
Can herd behavior lead to a bubble in a financial market?
A bubble in the financial market is caused by intense, often exuberant, market behavior that drives the price of an asset above its intrinsic value. Herding behavior can cause bubbles to inflate until investors are unable to buy the asset at which point collapse begins.
Why does herd mentality occur?
Human nature draws us to being part of communities or crowds. Whether this is caused by FOMO or wanting to conform in order to fit in, this way of thinking can shape many of our activities.
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Related Content
The herd mentality can be avoided, especially if you’re well-versed in financial literacy and discipline, maintain a strong budget and conduct your own analysis. The guides below can help you learn more about key financial topics and provide tips for saving and avoiding any herd bias pitfalls.
- How to Start Saving and Investing: Saving and investing should be part of any financial plan. Learn how to start and find tips to improve your strategies in this guide.
- A Financial Literacy Handbook for All Life Stages: Knowing how to handle your money, early on or late in your life, can be challenging. Learn methods for spending, financial management strategies and how to navigate life’s major expenses.
- Smart Spending in Retirement: Herd behavior can be present regardless of your age. Discover how you can spend your money wisely in retirement to avoid negative financial situations.
- Eco-Friendly Guide to Finances and Saving: Take an eco-friendly approach towards investing. From sustainable investing to green credit cards, you can start making conscious decisions that can benefit both the environment and your finances.
- How To Become Financially Secure At Every Stage Of Your Life: There are many ways to become financially secure at any point in your life. Dig into topics such as taxes, budgeting and retirement so you can plan ahead for the future.
About Nathan Paulus
Nathan Paulus is the Head of Content Marketing at MoneyGeek, with nearly 10 years of experience researching and creating content related to personal finance and financial literacy.
Paulus has a bachelor's degree in English from the University of St. Thomas, Houston. He enjoys helping people from all walks of life build stronger financial foundations.
sources
- CNBC. "Bed Bath & Beyond shares surged more than 60%, buoyed by meme stock mania, product news." Accessed November 1, 2024.
- Muchnik, L., Aral, S. and Taylor, S. J. "Social Influence Bias: A Randomized Experiment." Accessed November 1, 2024.