By Albert Phung Key Concept No. Herd Behavior One of the most infamous financial events in recent memory would be the bursting of the internet bubble. However, this wasn't the first time that events like this have happened in the markets.

How could something so catastrophic be allowed to happen over and over again?

The answer to this question can be found in what some people believe to be a hardwired human attribute: Individually, however, most people would not necessarily make the same choice. There are a couple of reasons why herd behavior happens. The first is the social pressure of conformity. You probably know from experience that this can be a powerful force.

This is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast.

Therefore, following the group is an ideal way of becoming a member.

The second reason is the common rationale that it's unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don't. This is especially prevalent in situations in which an individual has very little experience. The Dotcom Herd Herd behavior was exhibited in the late s as venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies, even though most of these dotcoms did not at the time have financially sound business models.

The driving force that seemed to compel these investors to sink their money into such an uncertain venture was the reassurance they got from seeing so many others do the same thing. A strong herd mentality can even affect financial professionals. The ultimate goal of a money manager is to follow an investment strategy to maximize a client's invested wealth.

Prospect Theory and Herding Behavior in the Stock Market | Lin | Journal of Financial Studies

The problem lies in the amount of scrutiny that money managers receive from their clients whenever a new investment fad pops up. For example, a wealthy client may have heard about an investment gimmick that's gaining notoriety and inquires about whether the money manager employs a similar "strategy". In many cases, it's tempting for a money manager to follow the herd of investment professionals.

After all, if the aforementioned gimmick pans out, his clients will be happy. If it doesn't, that money manager can justify his poor decision by pointing out just how many others were led astray. The Costs of Being Led Astray Herd behavior, as the dotcom bubble illustrates, is usually not a very profitable investment strategy.

Investors that employ a herd-mentality investment strategy constantly buy and sell their investment assets in pursuit of the newest and hottest investment trends.

For example, if a herd investor hears that internet stocks are the best investments right now, he will free up his investment capital and then dump it on internet stocks. If biotech stocks are all the rage six months later, he'll probably move his money again, perhaps before he has even experienced significant appreciation in his internet investments.

Prospect theory and herding behavior in the stock market in mind that all this frequent buying and selling incurs a substantial amount of transaction costs, which can eat away at available profits.

BEHAVIORAL FINANCE: AN INTRODUCTION TO THE PRINCIPLES GOVERNING INVESTOR BEHAVIOR IN STOCK MARKETS | IASET US - urisofod.web.fc2.com

Furthermore, it's extremely difficult to time trades correctly to ensure that you are entering your position right when the trend is starting. By the time a herd investor knows about the newest options speculation strategies, most other investors have already taken advantage of this news, and the strategy's wealth-maximizing potential has how does wiki earn money already peaked.

This means that many herd-following investors will probably be entering into the game too late and are likely to lose money as those at the front of the pack move on to other strategies. Avoiding the Herd Mentality While it's tempting to follow the newest investment trends, an investor is generally better off steering clear of the herd.

Just because prospect theory and herding behavior in the stock market is jumping on a certain investment "bandwagon" doesn't necessarily mean the strategy is correct. Therefore, the soundest advice is to always do your homework before following any trend. Just remember that particular bni money makers omaha favored by the herd can easily become overvalued because the investment's high values are usually based on optimism and not on the underlying fundamentals.

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Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. Key Concepts - Herd Behavior By Albert Phung Share.

Key Concepts - Anchoring Behavioral Finance: Key Concepts - Mental Accounting Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias Behavioral Finance: Key Concepts - Gambler's Fallacy Behavioral Finance: Key Concepts - Herd Behavior Behavioral Finance: Key Concepts - Overconfidence Behavioral Finance: Key Concepts - Overreaction and Availability Bias Behavioral Finance: Key Concepts - Prospect Theory Behavioral Finance: If you have ever heard "the trend is your friend" and believed it, you may be a fan of herd instinct mentality.

This is an environment where, just like with fashion, masses of people follow a Just like private investors, analysts are sometimes guilty of following the herd and failing to think independently. Use caution and commonsense when making trades according to herd instinct — use stop losses, avoid complacency and plan your exit strategy.

Investors are only human, and their irrational behavior can often move the market. Learn how the herd is almost always wrong, or at least late in jumping on the bandwagon.

Momentum traders are always trying to ride the herd. In these three situations, however, they may end up getting trampled.

Prospect Theory and Herding Behavior in the Stock Market | Lin | Journal of Financial Studies

Curious about how emotions and biases affect the market? Find some useful insight here.

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