In finance, the herd instinct drives investors to make decisions as a group, rather than independently. This behavior has been observed in groups of investors for centuries, and similar decision making tendencies can be seen in other areas of human life as well. Psychological research suggests there may be an evolutionary imperative. Early humans who acted in groups to avoid threats were more likely to survive, for example, than loners who failed to remain alert to what the rest of the group was doing.
Investors watch each other closely, because they are aware of their own impacts on markets. When an investor with influence makes a decision, others may follow suit, which can create a snowball effect. Someone might, for example, sell off stock in a company that appears to be wavering, which signals other investors to do the same. The herd instinct can create a massive sell-off that causes the price to drop, which reinforces the behavior. Investors note that they made the right decision because the price dropped, not recognizing that it may have done so because they panicked.
Many investments are undertaken by agents who act on behalf of clients, rather than investors directly. Agents juggling multiple clients may influence the market as they make a variety of decisions and trigger the herd instinct. This can be particularly true with agents known to represent large firms or big investors, as some people may assume they have access to additional information or have a good head for decisions. The trust placed in particular agents can create an outsize effect when they buy or sell stock.
Some markets have controls in place to address concerns about herd instinct. If prices drop precipitously, for example, they could temporarily suspend trading to allow the market to stabilize before opening the floor again. Markets may close in an emergency when political events might trigger investment panic, as well. Officials may also regulate certain kinds of trades to prevent herd decisions or limit their impacts. This can reduce the risk of unnecessary volatility during the trading day.
Various studies on herd instinct show how it can contribute to the development of investment bubbles. Increased investor involvement can amplify certain market effects and may inflate situations. As bubbles grow, more investors are attracted, adding to the problem. When they start to panic, the result can be a sudden and rapid fall well below fair market value as investors jockey for positions.
