MG: What are some questions that consumers can ask themselves to identify if they’re making a decision based on herd behavior?

Ye Li: Herd instinct is the tendency of individuals to follow the behavior of others, often without independent analysis or decision-making. This behavior is driven by the belief that the collective actions of a group are more likely to be correct or beneficial, leading individuals to conform. Another term for this is following social norms.

That said, here are some questions to ask:

• Am I making this decision because others are doing it?
• Do I feel pressured to conform to the group?
• Would I make the same decision if I were alone?
• Have I thoroughly researched and considered the alternatives?
• Does this choice align with my personal goals and values?

 

MG: How can consumers best avoid herd behavior?

Ye Li: Other than noticing when they're just following the herd by asking the questions above, the best way is to make your own decision before you know what others are doing. If you already know, do your own research and clarify your goals and values rather than lean on what the crowd values. And finally, embrace being a contrarian; it can be a great way to stand out as an individual.

 

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What Is Herd Instinct?

As a collective, we are social beings. Oftentimes, this means we are influenced by the opinions and decisions of others. When we make decisions based on what others believe or do, we are falling into herd instinct or herding. The concept, “if everyone is doing it, it must be a good thing” is how so many of us go with the crowd and make choices we perceive as the best, safe or good. Some common herding examples are selecting a restaurant based on its positive reviews or making investments based on other investors’ without analyzing our options for ourselves.

 

Why Do People Follow the Crowd?

Humans are social creatures and because of this, we are easily affected by others. We tend to fall into herd instinct and seek acceptance and inclusion from others who hold the same views and values as we do to shape our beliefs and decisions.

In general, following the crowd is also far simpler, which is why so many of us do it. After all, it’s difficult to make informed decisions by gathering pertinent information on all interesting products and services. It’s far easier to follow others’ decisions, especially if you believe they have done their research or know best. While this can help in the case of buying a product or getting a service, this mindset is not ideal when it comes to big life decisions, such as your career path or your finances.

 

Understanding Herd Instinct

Herd instinct or herd behavior is defined by a lack of independent decision-making, causing one to think and behave similarly to everyone else. This can manifest in what we buy or how we think and is present in many parts of our lives, such as choosing services, food options, purchasing products and investing our money.

To clarify, herd instinct in finance happens when investors follow in the footsteps of others. By doing so, they are being influenced by emotion and instinct instead of relying on their own independent analysis, which is an essential step before investing in any product.

Herd instinct and influence is all around us. The following are some common examples of where herding can show up in our everyday lives.

 

Herd Instinct Example: Choosing Where to Eat

Even the simplest decisions, such as where to eat or what to order, can be influenced by herd instinct. Imagine you’re out for the evening with your friends, you’re hungry and have two restaurants nearby. The first one has a crowd lined up around the corner and the other one barely has any patrons. If you were following the herd instinct, you may end up choosing the one with a crowd because you presume it likely has better food and is popular for a reason.

 

Key Takeaway

Rash decisions like choosing a restaurant based on the crowd can be harmful, even on a small scale. For instance, you may end up spending more per dish at the restaurant than you intended and justify it because the restaurant is popular. In turn, your choice may have you going over your spending budget.
 

 

Herd Instinct Example: Avoiding the Fear of Missing Out (FOMO)

The fear of missing out (FOMO) can easily cause us to make hasty decisions. For example, a subset of traders drove up the price of Bed Bath & Beyond’s stocks by more than 60%. This happened in line with the rise of “meme stocks,” which are stocks that have a following from online communities and rise and fall based on their narratives and conversations.

 

Key Takeaway

Bed Bath & Beyond and its stock increase demonstrate how herd behavior and overconfidence can impact the market. The rise in price didn’t occur because the company made strong financial moves. Rather, it rose due to retail trader interest and their fear of missing out (FOMO) on trends. In reality, good investment decisions should be made based on ample research on the company.

The graph below shows how Bed Bath & Beyond's stocks spiked in June 2021 compared to the rest of the year.

 

Herd Instinct Example: Making Purchases

Everyday purchases are also affected by herding. We may end up buying a popular product we see online simply because it’s trending, but later discover it’s not that great or that it doesn’t really fit our needs or lifestyle. For instance, if you’re shopping for a particular type of sunscreen but haven’t done your research, you may gravitate towards popular name brands you recognize.

 

Key Takeaway

In the long run, basing your decisions on what others buy can impact your pocketbook, provide you with an item that doesn’t match your needs and result in you having to buy another product because you didn’t do your research prior to shopping.

For instance, reviews and star ratings can influence people's purchasing decisions. The more stars an item has, the more you are likely to think the product is exceptional, which may not be the case. Stars ratings and reviews are examples of herd instinct.

Another example would be how we view a company or brand online. In a 2013 study, having a prior positive and negative social influence affects the way we rate the company or brand. The study concluded that when the initial rating is a positive one, there is a 25% chance that the ratings after would also be positive.

 

Herd Instinct Example: Buying Stocks

First time investors can be easily influenced by the herd instinct and make poor financial decisions. For example, they may end up buying certain stocks or selling them based on societal influences and market chatter.

 

Key Takeaway

For instance, if you learn some of your coworkers are making gains from a certain stock or cryptocurrency, you may end up buying the same in order to reap the same benefits. However, without proper research, you can’t guarantee the same benefits and may end up buying at a price that’s too high, which can ultimately result in losses.

 

How to Escape Herd Instinct

Blindly giving into the herd mentality bias can be damaging for your finances. While it is challenging to curb your impulse to join the crowd, there are steps you can take to avoid following the herd.
 

1. Learn to identify herd behavior
When you understand the concept of herd instinct, it can be easier to identify when it’s occurring. Remember, the herd doesn’t know something you don’t; rather, the herd trusts the popular opinion as the most optimal choice, and some may be simply afraid of missing out.

2. Know that you have options
Try not to take things at face value. By doing your research, you can better understand the choices you have.

3. Don’t factor in the crowd
It’s easy to get caught up in the crowd’s opinions and choices. It’s also worth noting that the crowd does make some wise choices. However, it’s better to remove outside influence from your purchasing decisions. This way, you’re using logic, reason and value of your needs to drive choice versus those of others.

4. Evaluate your decisions rationally
Stress, fear and emotions can impact you from rational decision making. If others are rushing to do or buy a certain thing, don’t follow them. Take a step back and examine the merits and drawbacks of the situation.

5. Stick to a budget
Determine how much money to set aside per paycheck for savings and other necessities by creating and sticking to a budget. This can help you be more mindful of your purchases and avoid overspending or splurging situations that herd mentality can create.

 

Herding Behavior and Investment Decision

When it comes to investing, friends, neighbors and acquaintances can easily sway purchasing decisions. Imagine some of your friends invested in a stock that is continuously increasing in value and you haven’t yet taken the leap to invest, too. They poke fun at you for not jumping on this amazing opportunity and pressure you to act on investing quickly. You end up buying the stock because of their comments and influence and hope you’ll be as successful as they have been by reaping the same benefits. While this may work out on occasion, this strategy is not fruitful for an investor in the long run.

The herd effect or following the crowd can lead to trends amplifying beyond the fundamental rules of trading. People can drive up prices when they pile into investments because of FOMO or because they heard something positive but have not done their own due diligence to investigate its validity. As a result, this irrational exuberance is an unstable asset bubble that ultimately bursts causing prices to drop and not rise again, possibly ever.
 

5 Rules For Avoiding Herding in Investing

While there can be some benefits to herding, such as passive index investing that follows a herd-type strategy, it’s best for inexperienced traders to avoid it altogether. Prior to investing, review the tips below to avoid falling prey to the herd mentality.

• Keep your financial goals in mind. While risky investments initially seem like a potential jackpot, remember that you’re more likely to lose your money than to gain from it. If this doesn’t support your future goals or can hinder them, then it’s best to avoid that investment. Hold yourself accountable with your money and live with financial intention.
• Do your research. The herd mentality keeps you from doing your own research, which is essential before you invest funds into any product. Make a conscious effort to form your own opinion through research and understanding of the investment you’re about to make.
• Go at it alone. It can be nerve-wracking to invest in something when no one else you know is doing it. However, to avoid the herd instinct, you need to be okay with investing in new things, especially if your research shows it may be a wise investment.
• Consult a professional. If you’re new to the market and you need some guidance, look into finding a professional advisor. Gaining professional input on your research, analysis and preferences can help you determine if a particular investment is a good option for you.
• Take your time. Don’t rush into a market purely because others are. Remember that investing wisely is one of the key ways to start saving money and reach your goals. This should be the driving force behind your investment decisions.

 

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All images courtesy of MoneyGeek