Herd Behavior
What is Herd Behavior?
Herd behavior is copying what a crowd is doing instead of acting on your own information, which can push prices and decisions far from the fundamentals.
Copying the crowd is not always irrational: if other people may know something you do not, their actions are information, and following them can be the sensible move. The trouble is that once enough people ignore their own signal and copy, the crowd stops carrying new information and starts repeating one early opinion, a pattern called an information cascade. Career pressure adds to it, since being wrong alongside everyone else costs a fund manager or forecaster less than being wrong alone. The results are asset bubbles, sudden crashes when the direction flips, bank runs where withdrawing is rational only because others are withdrawing, and fads in consumer goods. Herding differs from an ordinary demand shift because the trigger is other people's behavior rather than a change in prices, income or tastes.
Herd Behavior: a worked example
A small bank with no deposit insurance holds $100 million in deposits but only $12 million in cash, with the rest lent out. Nothing about the loans changes, but a rumor spreads and 200 depositors line up. Other customers see the line, infer that those people know something, and join. Once withdrawals pass $12 million the bank cannot pay, so a depositor who waits gets nothing while one who runs gets paid in full. Withdrawing is the right individual move precisely because others are withdrawing, and a bank that was solvent at the start is closed by the queue rather than by its loan book.
The mistake students make with herd behavior
The common belief is that herding proves people are stupid. Each person in a cascade may be reasoning correctly from what they can see; the failure is at the group level, where private information stops reaching the price. A second error is calling any popular trend herding. If people buy the same thing because they independently judged it good, that is ordinary demand, not a herd.
Herd Behavior questions
Is herd behavior irrational?
Herd behavior is often individually rational even when the group outcome is bad. Following people who may be better informed is a reasonable use of the evidence available to you, and a fund manager who tracks the consensus carries less career risk than one who does not. The problem is that the crowd stops adding information once members stop acting on what they personally know.
What is an information cascade?
An information cascade happens when people start ignoring their own private information and simply copy the choices made before them. Once a few early movers set a direction, later movers rationally follow, so the crowd ends up repeating a small amount of original evidence rather than pooling everyone's. Cascades are fragile, because one credible new signal can flip the whole group.
How does herd behavior cause asset bubbles?
Herd behavior inflates bubbles because rising prices attract buyers who are reacting to the buying itself rather than to any change in what the asset earns. Each wave of purchases pushes the price up, which appears to confirm the decision and draws in the next wave. The same mechanism runs in reverse on the way down, which is why crashes tend to be faster than the climbs.
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