Herd Mentality and Financial Markets

Some animals, such as cows and sheep, have a basic instinct to group together into herds. They form groups that live and move together in such a way that they no longer act as individual animals. The group acts as one unit without regard to the individuals in the group. The separate members of the group usually have no idea why they are doing what they are doing. The only thing that they know and care about is what all of the other members are doing. They just follow everyone else regardless of reason. This behavior is referred to as herd instinct. Humans can also act in this same way. When they do, it is called herd mentality. A recent study published in Animal Behaviour Journal found that in large groups of 200 or more, it only takes five percent of the crowd to influence the rest of the members (Animal Behaviour) . This herd mentality can play a major part in our civilization, especially when in comes to money.

In 1971, W.D. Hamilton, an evolutionary biologist, wrote a paper called "Geometry For The Selfish Herd". In this paper, he implied that the individuals in a group try to reduce the amount of danger to themselves by trying to get as much into the center of a group as possible. So even though the group may appear to be acting as on unit, it is actually a group made of separate members that are only looking out for themselves (Hamilton). Since one of the things in our culture that tend to create fear in people is money or the lack thereof, it is easy to see how strong and effect that the herd mentality can have on financial markets. Understanding the inner workings of financial markets can a very complicated thing. Many people just simply do not know enough about money to make wise decisions even in good times. In good times, they see people making money doing one thing, so everyone says to themselves, this must be what we should do to become rich. Of course, even then, most likely they do not understand the forces at play. However, when the economy starts to break down, everyone panics. When people panic, they have a tendency to lose their normal logical problem solving. The fear drives them to find the quickest way to safety. Just like Hamilton believed, when this happens, they fall into herd mentality thinking.

The stock market is an excellent example of herd mentality at work on a daily basis. Although some people feel that the herd mentality is actually on the extreme end of the feeling of the market (Prechter), the markets rise and fall based on this simple principle. In fact, the entire market is based on speculation as to what direction the herd will go. When people see that others are buying, they start buying. When they see that others are selling, they start selling. Many of the people propbably have no idea why or what is going on. They may not have the knowledge to understand. Even those that do have a good understanding of how the market works, can get caught up in the frenzy. But the interesting thing is the herd moves because it is afraid the market will move a certain way when in reality the fact that the herd is moving in that direction, actually causes it to reach the expecting end. The fear of what might happen, actually causes the situation to happen. Therefore, a self-fullfilling prophacy is created.

It is now clear that our country is currently in a recession. If you take the concept of herd mentatity and look over the last year, it is clear that the herd mentality definitely had a part in our current finanical situation. Since the beginning of the year, all that was being reported in the news was how bad the economy was. The reporting started to intinsify beginning around the summer. The news began reporting that banks were failing. The next morning, people were lined up outside their banks trying to withdrawal all of their money. They may or may not have understood that their money was federally insured up to $100,000. Either way, everyone else was withdrawing their money, so they felt that they needed to withdrawal theirs. In doing so, they actually caused the banks to fail. Once again, a self-fullfilling prophacy was created.

Right now, the herd seems to be saying that it is time to sell stocks and real estate. The herd is moving away from investments. People in the herd are just excepting this to be the truth. Even when information becomes available that suggest that a different action should be tried, the herd will usually continue on the way it is going (Journal of Political Economy) . However, the reality is, the best thing to do is go against the herd. The economy is based on supply and demand. Since the herd is selling everything, supply is up and demand is down. Now is the time to take advantage of the herd mentality situation. By buying now, great prices are able to be obtained. Once the herd reverses, which it always does, then it will be time to sell.

Herd mentality is all around us. It can have a major influence on every aspect of our lives. It can even influence where we eat and shop (Banerjee). Nowhere is this affect more powerful than in the financial world. Even if we are not ourselves, investors, the affect will trickle down to everyone. By understanding the nature of the herd mentality, we can keep ourselves from mindless following everyone else. Instead, if you understand it, you can take advantage of it.

Works Cited

W. D. Hamilton (1971), "Geometry for the Selfish Herd," Journal of Theoretical Biology, Volume 31, Issue 2, pp. 295-311.

Robert Prechter, The Wave Principle of Human Social Behavior, New Classics Library (1999), pp. 152-153.

Consensus decision making in human crowds, Animal Behaviour,
by: John R Dyer, Christos C Ioannou, Lesley J Morrell, Darren P Croft, Iain D Couzin, Dean A Waters, Jens Krause

Abhijit V. Banerjee, "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, Vol. 107, No. 3, pp. 797-817.

Sushil Bikhchandani, David Hirshleifer, Ivo Welch. October 1992. "A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades." Journal of Political Economy, Vol. 100, No.5, pp. 992-1026.