How to Identify Herd Mentality Bias A Comprehensive Guide

A study done by Burke, Leykin, Li and Zhang in 2014 on the social influence on shopper behavior shows that shoppers are influenced by direct interactions with companions, and as a group size grows, herd behaviour becomes more apparent. The other people in the store not only served as company, but also provided an inference point on which potential customers could model their behavior and make purchase decisions, as with any reference group or community. In the case of stock market bubbles, the optimal behaviour for an individual may be to do what everyone else is doing, because even though everyone knows that they are in a bubble, until it bursts, most profit is to be made by staying in the market. In this case the term “herd behaviour” is relatively appropriate, because the “collective” behaviour emerges from uncoordinated individual choices. Interestingly, though the behaviour of the group is evidently irrational, the behaviour of the individuals that cause it is rational at least in the short term, though it does show some abandonment of risk aversion, as the crash usually occurs without much warning. These phenomena are now much better understood as a result of investigations in experimental economics and behavioural finance, particularly by Nobel laureates Vernon Smith and Daniel Kahneman.

When you are with a group that wants to stay out and party all night, and you don’t want to but do it anyway, again, you are part of a herd. Herd behavior can be good if it is temporary and has a purpose, such as keeping https://forexhero.info/python-linear-optimization-package/ you from harm. However, it can also be bad, especially when it replaces critical thinking skills and conscience. It’s important to be aware of not only the choices you make but why you are making those choices.

Cass Sunstein on Ten Common Behavioural Nudges

All of us have probably participated in some sort of herd behavior, intentionally or not intentionally. When walking in a crowd and everyone stops for no discernable reason, and you do too, you are exhibiting herd behavior. When you are in a grocery store, someone screams, and everyone runs out of the store, and you do too.

It could be useful to stop and take the time to consider your goals before you begin trading. This could include reviewing whether the underlying asset has inherent value that matches the quantity of orders. Once you are aware of herding they can look at securities with a greater level of scrutiny. A more recent example would be the dotcom bubble of the late 1990s and early 2000s.

Animal behavior

Additionally, sometimes, what may seem like herd mentality, with countless traders making the same choices and driving up the price, may just be an example of market sentiment. Herding can be a case of collective irrationality, but that does not necessarily mean that traders cannot use it. If a trader thinks they are able to identify when a market is in a speculative bubble due to herding, then they can use this in their decision-making process. One of the first written accounts that linked economic bubbles to herding was in Charles Mackay’s 1841 study of crowd psychology Extraordinary Popular Delusions and the Madness of Crowds.

Transmission-based theories are theories that argue that herd behavior is caused by a group’s social pressure to conform to group influence, and the individual is expected to adopt the group’s mentality. The group transmits or communicates what it expects of the individual, and the herd behavior can be intentional or unintentional, taking its cues from other members of the group. The herd instinct or herd behavior is evident when humans demonstrate in the streets, go on strike, or attend sporting events. We also see it in episodes of mob violence, opinion-forming, decision-making, and religious gatherings. Aside from various asset bubbles and manias, herding can help explain mob behavior or riots, fads, conspiracy theories, mass delusions, political and social movements, sports fandom, and many others. For instance, people may rush out to buy the newest smartphone because of its popularity with other consumers.

Risk Management

Herding or following the crowd can cause trends to amplify well-beyond fundamentals. As people pile into investments for fear of missing out, or because they have heard something positive but have not actually done their own due diligence, prices can skyrocket. This irrational exuberance can lead to unstable asset bubbles that ultimately pop. The term herd instinct refers to a phenomenon where people join groups and follow the actions of others under the assumption that other individuals have already done their research. Herd instincts are common in all aspects of society, even within the financial sector, where investors follow what they perceive other investors are doing, rather than relying on their own analysis. Pattern-based theories teach that we pattern our behaviors on those we think are wiser or know better, and are cued by environmental, outside factors.

• Consumers may take a shortcut to follow a herd — according to which people discount their own information to imitate others.
• If it doesn’t, that money manager can justify his poor decision by pointing out just how many others were led astray.
• First, take time to think through responses and actions before making them.

Herd behavior can be instigated through mechanism of transmissions—how something is communicated to let us know what behavior is expected of us. Herd behavior can also be a pattern of interactions—learned or instinctual behaviors that are based on who we interact with. When a peaceful protest devolves into a riot, it is a prime example of herd mentality. Many of the people who participate in the violence would never make such a choice on their own. But, once a crowd of their peers acts that way, they join in without thinking twice.

What causes herd mentality?

When we use it negatively, it describes a lack of thoughtfulness or individual decision-making. Consider taking time to assess whether buying into a market suits your strategy. Even if this risks being behind the curve, it is all part of the discipline and could help you avoid buying into fads.

• Keep in mind that all this frequent buying and selling incurs transaction costs, which can eat away at available profits.
• Herd behavior can also be a pattern of interactions—learned or instinctual behaviors that are based on who we interact with.
• In The Theory of the Leisure Class, Thorstein Veblen explained economic behavior in terms of social influences such as “emulation,” where some members of a group mimic other members of higher status.
• Thousands of wildebeests are fleeing together from the pursuit of a lion.
• A herd instinct is a behavior wherein people tend to react to the actions of others and follow their lead.

On the interactions between individuals and groups in a social learning context, group forces and group motives are important, reflecting not only imitation and conscious identification with group but also group-centred goals and behaviour. Imitation and suggestion reinforce group situations and group coherence but are not the necessary conditions for being part of a group (Katona 1975, pp. 50–51). Reference groups give standards for behaviour, and group-centred belonging and motivation are more likely to be important in small groups (Katona 1975, p. 51). Emotion, affect and decision-making are intertwined in the economic and financial world but until recently, economic analysis has neglected the role of emotions in economic decision-making (Elster 1996, 1998). Rational choice theories in economics tend to assume homogeneous, self-interested individuals employing universally rational methods of decision-making. Risk, for example, can be characterized as a feeling and feedback effects can intensify fear responses to evaluations of risk, precipitating panics.