Now I am a million-dollar rich. But I actually wrote a check for my entire bank account and gave it to my brother. All he did was reflect my action. Herd mentality is one such behavior, where the investors blindly follow the crowd and place their nets accordingly. In short, they are just the sheep of the market directed towards a huge fall.
What does Herd Mentality mean?
Have you ever thought about the reasons as to why kids cry? One among the many would be the need for something which another kid owns. We adults reflect the same behavior. We simply follow the choice of the crowd. Be it a dress or a gadget or movie. We want to be in the trend and hate to be left out. So we try our level best to mingle with what the majority does or says right.
In the process, we fail to analyze if the taken decision is really going to impact us positively or not. Our traditional beliefs might be a trigger for such actions.
This trend has taken itself to the floors of the market as well. If you closely watch certain products' price movements, you will be shocked to find this behavior behind it. In finance, this behavior is termed as "Herd mentality," which got its name from none other than the sheep, which always follows the flock.
Herd behavior surfaces when investors follow the actions of the majority. They blindly rely upon the perceptions made by other investors and fail to cross-check their actions. In simple words, herd behavior is showcased by the investors when all of them copy a particular action without making a proper company analysis. This sort of behavior is also known as herding.
Consider a situation where your friend claims that the stock of XYZ company is next Multibagger. In that case, your next instinct would be, purchasing it right away. This is a reflection of herd behavior.
Reasons for the occurrence of Herd Mentality
By nature, we are always built to be a part of society. Though we possess unique qualities, we try to blend in with the crowd and find it highly difficult to go against it. While trading in the markets, this behavior might pop up, affecting our decision. One of the reasons for this is our fear of being left out. We don't want to miss an opportunity of making money. We believe that what the majority does can never go wrong.
But the hard truth is such decisions supported by herd mentality always fetch you more loss than profit. This can lead to huge market rallies, price rise, or falls. But as soon as the truth strikes the crowd, they starting reacting to it, causing a domino effect, which starts with a huge fall in price.
Example: We might follow what everyone, including your friends, relatives, or experts do. Or buy a stock that captures the headlines of everyday news. Here the price of the stock might be extremely inflated, far beyond its intrinsic value. Hence you won't be making any profit at all. The one that lands on profits will be those investors who went against the crowd and trusted analyzes. Also, the bubbles formed as a result of speculation are hard to spot as well.
So how do you stop it?
While it is the most common thing in the market, it is not impossible to overcome it. A few ways which you adapt to beat this obstacle out of your way are as follows,
- The first and foremost thing you can do is understand how the market proceeds and at least have a vague idea as to why the price of a particular asset class falls or increases. In that way, you will understand and figure out where the market goes wrong. Try to think rationally.
- Turning back to the basics is never a fault. When you are heading in a particular direction or following the markets, it is always beneficial to cross-check your actions once again. Try and evaluate the decisions you took and the possible outcomes. It is never wrong to pause for a moment, which might ultimately highlight the mistake and stop you from acquiring a great loss.
- Sometimes your research might be saying something, and the market might be believing something. It might be tough for you to choose a path. In such a situation, it is better to stock onto your decision provided it's reliable. You should be ready against the market.
Dotcom bubble burst
How could one miss out on the Dotcom bubble burst while speaking about herd mentality? It is one of the idle examples that had to be brought up while discussing this subject.
The dot com bubble burst, which happened between 1999-2000, was driven by investors who believed that tech stocks are more profitable and started investing huge chunks of money into it. The investors made the price of these stocks increase vastly. They also increased the price of those stocks, which generated less or no profit. Even IPO's were targeted. They blindly diverted their funds towards startups with the anticipation that they will become great someday. No one backed their activities by a well-researched analysis. If the crowd had stopped for a record and evaluated their actions, maybe they would have escaped a huge fall.
As anticipated, the conclusion was really nasty. People were afraid of missing a profitable buy. This created too much optimism and confidence in the market. But as soon as the bubble burst, the reality made its way forcing the investors to face the hard truth. Investors lost millions of dollars, with many companies going out-of-business. It was a perfect recipe for disaster.
History is never bored with such events, and they occur from time to time. All you can do is be on the side that escapes rather than getting stuck in the mice-trap.
The moral of the story would be to act logically when it comes to stock markets. At the end of the day, it is always intelligent to turn back towards fundamental analysis and run a thorough check on the company. While being a part of the crowd might be good in real life, as far as the share market is concerned it will lead you only to a deep pit. In fact, standing alone isn't all bad as well. Last and final thoughts, "have you ever done something like this?"