What it means
Herd instinct is one of the best-documented ideas in behavioural finance, the field that studies how psychology affects financial decisions. It arises partly from a reasonable assumption, that other people may know something you do not, and partly from the discomfort of standing apart from a crowd that appears to be making money.
Career incentives make the behaviour rational at the individual level even when it is damaging collectively. A fund manager who is wrong alongside everyone else keeps their job, while one who is wrong alone does not, which is why many portfolios cluster around the same holdings.
The mechanism is self-reinforcing while it lasts. Buying pushes prices up, rising prices attract media attention and new buyers, and the resulting gains appear to validate the original decision, until the flow of new money slows and the same dynamic runs in reverse.
Herding is not confined to stock markets. It appears in corporate strategy when whole industries pursue the same acquisitions, in property when everyone chases the same city, and inside companies when a meeting converges on a view because no one wants to be the lone dissenter.
The practical defences are procedural rather than heroic. Written investment criteria decided in advance, a formal devil's advocate role in decision meetings, and rebalancing rules that force selling into strength all reduce the pull of the crowd because they commit you to a position before the emotion arrives.
In practice
Real-world examples.
Example
A regional bank's credit committee approves aggressive property lending because three competitors have just done the same. Two years later the local market corrects and all four banks are holding similar bad loans.
Example
An employee moves the whole of her pension into a technology fund after a colleague mentions that everyone in the office has done well from it. She buys near a peak and sells eight months later after a 30% fall, converting a paper loss into a permanent one.
Example
A retailer's board approves opening 40 stores in a fast-growing city because two rivals announced expansion there. Rents rise on the back of the collective rush and none of the three chains achieves the returns each modelled.
Formula
Calculation
There is no single formula for herd instinct, but its cost is commonly measured as the behaviour gap: Behaviour gap = Investor dollar-weighted return - Fund time-weighted return, where the first reflects when money actually went in and out and the second reflects the fund's published performance.
Suppose a fund reports an average annual return of 9% over five years, but investors piled in after strong years and withdrew after weak ones, so their dollar-weighted return was 5.5%. The behaviour gap is 9% - 5.5% = 3.5 percentage points a year.
Apply that to a $250,000 investment. Held steadily, $250,000 compounding at 9% for five years grows to $250,000 x 1.09 to the power of five, which is about $384,656.
Buying and selling with the herd at 5.5% produces $250,000 x 1.055 to the power of five, or about $326,740. The difference of $384,656 - $326,740 = $57,916 is the price of chasing the crowd, and the investor owned the same fund throughout.Case study
Seen in the real world.
Kestrel Ridge Capital is a fictional, illustrative wealth manager whose clients collectively held $600,000,000 across its funds. Its flagship fund posted a strong run, and marketing highlighted it heavily, so new money arrived in large amounts after each good quarter.
Analysing five years of client flows, the firm found its flagship fund had returned 9% a year while the typical client had earned only 5.5%, because money arrived near peaks and left after falls. On a representative $250,000 account, that gap was worth about $57,916 over the period.
Kestrel Ridge changed how it worked rather than what it invested in. It introduced a rule that new money into any fund up more than 25% in a year would be phased in over six months, added an automatic rebalancing trigger, and stopped publishing quarterly performance league tables to clients. In this illustrative account, the average client return improved over the following three years even though the funds themselves performed no better.
Watch out
Common mistakes.
- Believing that a rising price is itself evidence that an asset is a good investment, when price momentum and underlying value are different things.
- Assuming professional investors are immune, when career risk and benchmark-hugging make institutional herding at least as common as retail herding.
- Treating contrarianism as an automatic cure, since being different from the crowd is not the same as being right and can be just as costly.
Questions
People also ask.
Is following the crowd always wrong?
No, because crowds are often correct about direction, and the danger lies in copying without understanding the reasoning or the price being paid.
How can a business reduce herding in its own decisions?
By assigning someone to argue the opposing case, setting decision criteria before options are presented, and collecting written views before group discussion begins.
What is the difference between herd instinct and momentum investing?
Herd instinct is an unexamined behavioural pull, while momentum investing is a deliberate, rules-based strategy that accepts trend-following with defined exit points.
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