Following are Contributions from California Institute of Finance students in response to this prompt:
What is “herd behavior’ Why and how are herds formed. What are their impacts on markets and hence financial decisions? What are some of the symptoms of this behavior? Can it be leveraged (in a risk-return framework) for generating excess/abnormal returns?
Herd behavior is when individuals group together and act as a group rather than as an individual. In relation to finance it usually occurs in response to some stimulus such as a negative financial report or world economic event when individuals are lacking the knowledge or self confidence in
their own decisions. Individuals buy or sell just because others are buying or selling, without anyone really knowing why.
This can cause extreme fluctuations in the market. For example; when everyone buys stocks because prices are rising and everyone else is buying; they are optimistic that gains will continue. Eventually this results in an overvalued market or stock. When this happens and it is recognized by large investment companies, they will start to pull out very fast. This starts a rapid drop and results in great losses to those who paid top dollar and do not react fast enough. This is also a typical result of herding in nature. The ones at the back of the herd are usually those who are the weakest and have the most to lose and are least likely to survive.
If however, one is astute enough to recognize the signs and predict the pull out, one could certainly make tremendous gains by pulling out at the peak and turning right around again and buying
after the collapse. This could certainly result in excessive returns.
Buying when everybody else is selling (along with some tech analysis to show the stock is undervalued) is one of the core principles behind Value Based investing theories
. The herd drives down the stock price below market value.
An often quoted Warren Buffet quote is: “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”
I worked for a Silicon Valley company during the dot com boom and bust. Post bust, I was able to buy shares at 66 cents each. They were over $150 each at the peak. 6 months later, the corporate raiders came in and bought the shares in a forced takeover in the 90 cent range. Shortly there the investment company takeover, they bought my shares at $1.20 each when they took the company private. Not a bad return for me for 1 year. A year
later they sold off the land in the heart of silicon valley the company owned for $10m. It netted out to be about about $150k less than they had in the entire purchase price of the company. Then they owned the patents, a cash business that generated $3m a year cash profit, land in Atlanta, Chicago, Boston, etc.
The tactic works, when you know what you are doing and have mitigated risk by doing rock solid research.
The tactic can backfire. I know people who bought K-Mart stock when it was in the pennies per share prior to going bankrupt. Some would call this trying to see if a dead cat will bounce.
The concept of Herds and business is growing fast beyond investments. Seth Godin’s book Tribes is all about watching people move in groups and carefully marketing to that group.
In a 2008 study, a researcher at Leeds University, led by Professor Jens Krause performed a series of experiments in order to understand human herd
mentality. He asked a group of volunteers to randomly walk down a hallway without talking to one another. A select few of the group were given more information about where they were to walk. The study showed that people ended up blindly following the few who appeared to know where they were going.
This is an interesting explanation as to why people tend to follow the crowd in making investment decisions. It is as if to appear equally informed of the right choice as the investors they read about in the morning paper, or they hear about on TV, whether those people leading the pack had any better insight than anyone else. As a result, many investors buy when the price has been driven up, and sell when the price has dropped. Rather than trying to time the market, wise investors should be looking for the overlooked undervaled investment. This article reminds me about the new car market. A beautiful but highly priced vehicle comes out in shiny new colors from a high end car
maker, and soon, everyone on the road is driving it. I think it is fairly safe to assume that if those drivers were asked about the engine, the gas mileage expected, or how various extra features on the car worked, they could not answer. They could however probably tell you which friends drive a similar car, or what the commercial for the car looked like.