-By Peehu Dwivedi
“The More You follow the Crowd, the Further away You get from the Truth”
Humans are social animals! When we see the crowd act in a certain way our herd instinct is to follow.
Herding behavior is a psychological phenomenon exhibited by investors, where they imitate the actions and decisions of a larger group, often without critical evaluation or independent judgment. When investors observe others buying or selling assets all together, they may feel compelled to follow suit, influencing the thought that the majority of people can’t be wrong and perhaps they possess insights beyond our current understanding. Fearing that they will miss out on potential gains or avoid losses being an outcast which often comes down to social pressure.
As a result of this misconception, people ignore their own information or perspectives, and that creates a distorted signal chain. These chains of behavior are called Information Cascades, influencing social dynamics on human behavior and the potential for systemic biases or irrationality in group settings. These information cascades help us explain everything from standard conformity to booms and crashes.
Herding and Market Bubbles: Dynamic Duo Market bubbles are periods in which the prices of assets, such as stocks, real estate, or commodities, rise rapidly and unpredictably. These bubbles are characterized by an abrupt surge in prices, which is caused by speculative buying and a widespread perception that prices will rise indefinitely. These bubbles often result in asset prices reaching levels that are significantly detached from their intrinsic or fundamental value.
STAGE 1- Formation and Expansion of the Bubble During this stage, investors observe others making substantial profits from speculative investments and fear missing out on potential gains. This fear compels them to join the trend, leading to a self-reinforcing cycle where more investors enter the market, driving prices even higher. As a result, the bubble inflates rapidly, fueled by the collective actions of investors following the crowd.
STAGE 2 - Recognition of Unsustainability In this stage, rational investors start to recognize the disconnect between asset prices and underlying fundamentals. They may choose to sell their positions, anticipating a reversal in market sentiment. However, the fear of missing out and the desire to profit further often outweigh rational considerations, leading to a delay in the burst of the bubble. Despite growing concerns about the sustainability of the inflated prices, the momentum of the bubble continues to build.
STAGE 3 - Bubble Burst During the final stage, market participants come to realize the unsustainable nature of the inflated prices. This realization triggers a sudden shift in sentiment, as investors rush to exit their positions simultaneously. The mass exodus of investors trying to sell their assets leads to a sharp decline in prices, often resulting in a market crash or bubble burst. This stage represents the culmination of the herding behavior-driven cycle, as the bubble collapses under the weight of its own unsustainability.
But the question arises about this herd behavior that we have ingrained over millions of years,
CAN WE RESIST THE IMPULSE TO FOLLOW THE HERD?
The tendency to follow the herd emerges from our social brain networks. The way our brains make decisions is by iteratively collecting shreds of evidence. The more evidences one collects, the more likely one is to make informed decisions. In order to mitigate herd behavior it is reasonable to neutralize the social pressure along with a firm conviction of your own that would allow more evidences to accumulate and they are more likely to make mindful decisions. Moreover, the mechanism underlying information cascades, individuals can make more informed decisions.
But, is it always detrimental to follow the crowd?
Most often the crowd is usually right until a turning point occurs. Usually, everyone takes a position earlier due to which market is headed in a particular upward direction and there are only a few traders left to push the trend up further. This is the point where the counter-trade initiates and moves the market in the opposite direction. Hence, herd mentality arises but this time traders start panic selling extensively to avoid further losses.
Taking the contrarian approach may help one to identify turning points, it is not merely doing the opposite of what everyone else is doing. In the contrarian approach, a trader studies the market and tries to come up with an innovative trading plan. These sorts of plans would require a great deal of experience and thought. Think of reasons why the majority of people may be wrong and then try to discover factors that may predict a change in the market condition. So, to avoid being a part of the herd, one needs to predict and anticipate the turning point and develop a trading plan to capitalize. Straying from your trading strategy may turn out to be fruitful for a few times but, in the long run, it is always individual discipline and an analytical approach that will win over the blind one.
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