Trading biases: herd behaviour and the bandwagon effect
By Neil Dennis
08:17, 25 August 2017
Herd behaviour and the bandwagon effect are instinctive impulses to follow the actions of a crowd, despite an individual's own, better, judgment.
The term herd behaviour refers to the behaviour of sheep and cattle or other animals that seek the protection of a large group for safety from predators.
In terms of finance, however, the herd is a group of investors who are led by the moves of influential individuals to make investment choices that they may not necessarily have made on their own.
A typical example of herd behaviour is the market bubble, where an asset – or group of assets – begins to gain in value, then picks up momentum as investors begin to herd into the same investment idea or market trend.
The bandwagon effect
Herd behaviour is seen in the bandwagon effect where an individual is compelled to take a particular action because other people are doing it.
The term originates in 19th century US political campaigning when a wagon carrying a small brass band – as in a traditional circus parade – would be used by political candidates to help drum up support. Campaign followers were encouraged to "jump on the bandwagon".
The call of the bandwagon is at its loudest when prices are at their highest - Source:Wikimedia CommonsIt has become ubiquitous as a pejorative term for someone who supports a popular cause unquestioningly – “You're just jumping on the bandwagon".
But, in the financial world the bandwagon effect can have far-reaching consequences.
Herd behaviour and market bubbles
One of the best examples of herd behaviour and the bandwagon effect is the market bubble – both in the forming of that bubble and when it eventually, and inevitably, bursts.
The Bubble
The 'dotcom' bubble of the late 1990s is a classic example of herd mentality and the bandwagon effect.
“Investor optimism was understandable”, says Economist journalist and former Financial Times markets editor Philip Coggan in the introduction of his book on the period, Easy Money.
“By the time of dotcom mania in late 1999, it had been a quarter of a century since the last bear market in equities.”
The horns and bugles of the bandwagon were calling. Coggan: "A new technology was going to change the world, how could it fail to make money? Anyone who didn't understand just didn't get it."
As Coggan explains – not only did the internet appear to offer unlimited riches to anyone brave enough to invest in it, it also offered the means of achieving it with online brokers offering easier access to share trading.
The herd mentality at the peak of the dotcom bubble was incredible. The Techmark index – newly formed to track the growing mass of technology and internet stocks in November 1999 – started at 2,421. Just five months later, in March 2000, it had swelled to 5,753.
The trouble is, just as the clarion call of the bandwagon was at its loudest, the top of the market had already been reached. And this is the major flaw of herd behaviour.
Just as the sheep that follow the herd, by the time they arrive the greenest grass has already been eaten.
The pursuit of money with no plan of how to achieve your goal other than blindly following others, can only ever fail or, at best, bring modest success.
By the time you hear the call of the bandwagon, the buying price is already too high. Likewise, by the time you get the sell signal, you're probably selling on the way back down – either at a very small profit or at a loss.
Why people herd
The innate need to herd is prevalent in many animals, and it is also a human trait.
We live in groups and find the best way to organise ourselves – politically, socially and economically – is in groups.
It is ingrained in our psyche: we are told to use our common sense, that public opinion dictates, we strive to keep up with the Joneses, and we believe that the most crowded restaurant must necessarily be the best.
Mostly it is an advantageous and acceptable way of living, but this mind-set can extend into some negative and very dangerous traits.
Mob mentality, for example, can be found in some extreme forms of nationalism.
Are the most crowded restaurants necessarily the best? Conventional wisdom tells us so - Source: Matt BiddulphOther associated behaviours can also have negative associations. Conventional wisdom – the body of ideas or explanations generally accepted as true by the public and/or by experts in a field – may seem a benign force.
But down the centuries, conventional wisdom disputed the thoughts of Newton and Darwin, and opposed parliamentary rule and universal suffrage.
Opposing the herd – contrarian investors
In life, it is often more advantageous to ignore the herd – plan your own set of actions: take the less busy route, try the quieter restaurant.
This is also true in investing. Make your own strategies, do your own research – or at least follow the research and strategies of someone who isn't the figurehead of a global movement.
As billionaire investor Warren Buffett says: "Be fearful when others are greedy and greedy when others are fearful."
He simply means that following your own path is likely to be more profitable. Sell when everyone else starts jumping on the bandwagon.
Conclusions
Some herding is inevitable and necessary for markets to function, and the best returns are not always going to come from contrarian investing.
For a stock to rise in value, a certain volume of sales needs to be achieved. This is why investment banks advise clients to buy and sell certain stocks to reach this critical mass to get a stock price moving.
And if you are index tracking, you're going to be collecting the stocks that most other index trackers already have in their portfolios.
But, a diverse strategy of asset allocation, avoiding the costs of constant transactions, will usually be a winning strategy.
Coggan quotes analyst Richard Hunter in Easy Money: “We’re not quite at the US stage where every taxi driver talks about the stock market, but stocks and shares are in the public consciousness.
“What we haven’t achieved yet is the education part, teaching people about risk and return.”
We’re not teaching them about trading biases either.