Traders' herd behaviour

herd of traders

The bursting of the Internet bubble is one of the most infamous financial events in recent history. However, markets have already experienced this type of event on several different occasions.

How can something so catastrophic happen over and over again?

The answer to this question can be found in what some consider to be a human attribute: the gregarious - or herd - instinct of traders, it represents the tendency of traders to imitate the actions (whether they're rational or irrational) of a large group of investors. Individually, most traders would not necessarily make the same choice.

There are several reasons why herding behaviour occurs. The first is the social pressure of compliance. You probably know from experience that it can be a powerful force. Most people are very sociable and have a natural desire to be accepted by a group, rather than being painted as outcasts. Therefore, following the group is an ideal way to become a member.

The second reason is based on the idea that a large group cannot make mistakes. After all, even if you're convinced that an idea is irrational or incorrect, you can still follow the herd if you believe that they know something that you don't know. This behaviour is particularly common in situations where an individual has very little experience.

Herding behaviour was highlighted in the late 1990s when capitalists and private investors invested huge amounts of money in Internet-related companies. The driving force behind these investors was that everyone was doing the same thing.

A herd mentality can even affect financial professionals. The ultimate goal of a fund manager is to follow an investment strategy that maximises the invested funds. The problem lies in the amount of control that fund managers receive from their clients each time a new investment method appears. For example, a wealthy client who discovers an investment that is gaining notoriety asks whether the fund manager is using a similar "strategy". In many cases, it is tempting for a fund manager to follow the herd of investment professionals. After all, it's also about ensuring that one's customers are happy.


The cost of straying off course

Gregarious behaviour generally doesn't lead to a very profitable investment strategy. Investors who employ an investment strategy based on a herd mentality are simply betting on current trends. For example, if an investor who follows the flock hears that internet stocks are the best investments at the moment, he will free up his investment capital to invest in internet shares. If biotech stocks are in fashion nine months later, he will probably move his money again.

Frequently buying or selling generates a substantial amount of transaction costs that can eat into one's profits. In addition, it is extremely difficult to enter the market at the right time when the trend begins. Once a trader that follows the herd tracks a trend, most other investors will have already benefited from this news and the potential of the strategy has probably already peaked. This means that many investors who follow the herds enter the game too late and are likely to lose money compared to the leaders who are ahead of the movement.


Avoiding herd mentality

Although it is tempting to follow recent trends, an investor will usually perform better if he doesn't follow the direction of the flock. Just because when everyone else is jumping on an investment bandwagon doesn't necessarily mean that the strategy is good. Therefore, the best advice is to always do your homework before following a trend.

Don't forget that some investments are favoured by the herd and they can easily become overvalued because the high values ​​of the investment are usually based on optimism and not on fundamentals.

N'oubliez pas que certains investissements sont favorisés par le troupeau et qu'ils peuvent facilement devenir surévaluer, car les valeurs élevées de l'investissement sont généralement basées sur l'optimisme et pas sur les fondamentaux.

Contents - behavioural finance theory