Herding behaviour refers to how individual decisions are influenced by group behaviour. It stems from the observation that if a herd of animals starts moving in one direction, all the animals want to follow the herd.
Why herding behaviour occurs
Following the crowd. In economics, we can see a similar behaviour. For example, if individuals see there is popular interest in buying a particular asset, they may take this popular support as a reason to follow the crowd. Because people consciously or unconsciously follow what others are doing – the market as a whole can display collective irrationality. It is a challenge to the efficient market hypothesis.
Deference to professionals. If a mortgage adviser suggests taking out a subprime mortgage – consciously or unconsciously we assume they must know what they are doing because they make a living from the industry.
Not getting left behind – easier to go with the flow. Another powerful element of human psychology is the desire not to get left behind or miss out. This can encourage people to follow market sentiment.
“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” – John Maynard Keynes. (General Theory, 1936)
This quote reflects Keynes’ observation that failing conventionally can often insulate you from criticism. If everyone else makes the same mistake, they are unlikely to blame you for it. However, if you take a contrarian view, you become a target for the majority opinion. If you get it wrong, when the majority make a correct decision, then you are isolated and feel embarrassed. Even if the ‘majority’ get the decision wrong, you may not win any friends by proving everyone else wrong. Therefore, following the crowd, puts you on the same playing field as your peers, and you avoid becoming a ‘loose cannon.’ This can be another reason for herding behaviour.
Where does herding behaviour occur?
Finance markets. Herding behaviour is more likely in the domain of finance and asset investment. It is an area where people lack specific expertise – and also where emotion can play an important role. For example, most individuals are not experts on the housing market. If house prices are rising and many ‘experts’ advocate buying, that might be the best information they have. Therefore, individuals can be swayed by movements of the market – on the grounds – other people probably know something I don’t.
Examples of herding behaviour
Dotcom bubble 1999-2000 Share price to earnings rose well above long-term average earning ratios – before market sentiment changed and share prices crashed.
Credit bubble 2003-2007
In the years 2003-2007, there was a global rise in house prices – financed by increased levels of borrowing and leverage. House prices grew faster than earnings and affordability, but despite prices becoming divorced from long-term price-earning ratios, several mechanisms kept the bubble going.
Individuals saw rising prices and felt a need to get on the property market to benefit from rising prices.
Potential homebuyers were encouraged by mortgage companies who had the incentive to keep selling mortgages. There was growth in subprime lending in the US and UK.
Despite mortgage companies lending more subprime lending, even credit rating agencies were taken in by positive expectations and marked this risky debt as safe.
The problem is that the rise in mortgage lending – especially the subprime mortgage lending was based on shaky foundations and where there were modest increases in interest rates in 2003-05, there was a rapid rise in home repossession as households realised it was a mistake to take out such a big mortgage.
A tradeable commodity. Bitcoin can fluctuate on the market. As the price of bitcoin rises, the price has swung in large fluctuations. In 2017, bitcoin went from being worth around $15 billion to $225 as interest in the crypto-currency has soared. It has also led to spin-offs with old-fashioned companies finding they can increase the value of their business by announcing spin-offs like dentacoin (digital coin to use in dental industry). Kodak, long struggling to make the transition from film to digital have also recently announced their entry into the brave new world of blockchain and cryptocurrency. Just the announcement was sufficient to see the share price increase 200 percent, with volume up 22,000 percent.
There is an element of herding and irrational exuberance with people joining these new ventures.
Herding and rational economic man
An assumption of classical economics is that on balance, individuals are rational and take decisions to maximise their utility. (See rational economic man) There is little room for irrational behaviours – such as ignoring real values and ‘following the crowd’. However, behavioural economics has investigated more cases where individuals are non-rational, but influenced by psychological factors.
This time is different. Asset bubbles are often justified on the grounds that ‘this time is different’ For example, in the dotcom bubble, the very high valuations for the internet were justified on the grounds that the internet was a groundbreaking new innovation. But, although the internet has become important, it has not been able to support the price to earnings ratios of the late 1990s.
Irrational exuberance – when people get caught up in the enthusiasm of a particular moment and get swept up by the general attitude to buying shares/assets.