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Finance Behavioral Investing and Herd Mentality

herd of sheep on dirt road during daytime

The stock market is often said to have a personality all of its own. This is understandable since investors, be they individuals or collective, are human beings. Therefore, they can react emotionally and sometimes irrationally in good and bad news.

Known as behavioral investing, in financial markets or stock trading, it is especially important to be aware of the herd mentality during periods of marketing turbulence in which investors become influenced by the crowd’s (or herd’s) emotional stampede, which causes them to react and decide irrationally in buying or selling stocks

This phenomenon of the crowd of herd mentality has been studied and analyzed by French social psychologist, Gustav Le Bon (1841-1931).

Investors Caught-up in Herd Mentality

Many investors tend to hunt in packs of the herd mentality by making investment decisions based on what the rest of the crowd is doing. Sometimes the media tends to perpetuate this style of investing, where sensational headlines are printed that often exaggerate the reality of the current market conditions. One moment, stock shares can be ruthlessly downgraded by the share market, and on another good day, they can be superfluously boosted.

Such print media headlines can lead to bandwagon jumping, where investors panic and react by buying or selling particular shares, or vice-versa. Whatever decision is made becomes decision of the herd, rather than the rational mind. When this happens, the herd mentality takes over. Panic replaces rational consideration, masking the true underlying value of the shares, or the strength of the company behind them.

It is important to remember that the way a decision is understood and a reaction to information may cause the investor to run the risk of potentially buying shares that are overvalued, of he/she may end up by selling a basically sound undervalued shares which have reached the bottom of the cycle and have a favorable earnings potential.

Other Identified Emotional and/or Psychological Impulses

Some of these identified impulses which an investor may react to, and can be overtaken by herd mentality behavioural investing.

  • Anchoring – Placing much emphasis on credence of recent price movements, instead of a share’s long-term history.
  • Inaction to Trade at the Opportune Time – Procrastination occurs from not taking action when necessary to buy or sell shares.
  • Mental Accounting – Holding of an emotional attachment to a particular investment.
  • Overconfidence – Trading too much or taking too much risk in one area.

In herd mentality or crowd behaviour, two things can take place: over-reaction in which for a little piece of good or bad news about the stock market, investors can become overly pessimistic when the market falls, and on the other hand, they can be too optimistic when the market rises.