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    September 2012
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    When Are Stocks Like Hotdogs?

    Alan Fustey

    Herding refers to the phenomenon of how individuals, who are acting independently, can sometimes unintentionally act together as a group.

    Herding behaviours are common in your everyday decisions. Imagine you are walking down the street and you approach two hot dog vendors. Neither has a line of people waiting to order, so at random you choose one of the vendors. Soon another two individuals stroll down the street in search of a place to eat and they see you at one vendor, while the other vendor still does not have a customer. On the assumption that having customers makes one vendor a better choice, they join the line with you. Another passerby sees that one vendor is doing more business than the other, processes the same information and then joins the growing line, while the other vendor sits idle.

    Financial market history is littered with examples of investments that begin as new ideas, then become fads, which turn into bubbles and inevitably into busts: Tulip mania in Holland in the 17th century, the South Sea Island bubble of the 18th century, the U.S. stock market boom of the 1920s, the internet and technology investment boom of the 1980s and, more recently, the residential real estate bubble that occurred in many developed economies in late 2000s. These episodes are often cited as examples of herding behaviour.

    Herd behaviour has the potential to increase financial market volatility because in many financial market environments, individual investors are influenced by the decisions of other investors, resulting in them all herding towards the same investments. Suppose that 100 potential investors each make their own independent judgments about the potential profitability of investing in a particular stock. Only 20 of the investors believe that this is likely to be a profitable investment at the current price, while the other 80 believe that it is not worthwhile.

    This is the same type of environment in which real financial markets function, as buyers and sellers of securities always having differing opinions regarding the same security. When you want to purchase a stock, someone must be willing to sell it.

    Each investor is the only one who knows their own estimate of the profitability of an investment. They have no way of ascertaining the judgments of the other investors or whether a majority have decided to purchase the stock. However, if these investors did share their knowledge about the estimate of the potential profitability of investment, they would collectively decide that investing in the stock is not a good idea (80 ‘against’ vs. 20 ‘for’).

    Imagine that these 100 investors do not all make their investment decisions at exactly the same moment. Instead, the first few investors that decide to act are the 20 investors who believe that this will be a profitable investment, and so they purchase the stock. Several of the investors who choose not to invest in the stock notice the increase in the buying activity and the resulting increase in the price of the stock, so they reverse their original decision and also purchase the stock, thinking that there must have been something wrong with their original opinion of value. In turn, this begins a cascading effect that results in most of the remaining individuals reversing their original decisions and now purchasing the stock as they use the same flawed decision-making process.

    Once all the investors have finished purchasing the stock, the buying volume is finished and the price begins to decline. Some of the original 20 investors that purchased the stock early have made a profit, so they begin to sell. Other investors notice the change of direction in the stock price and they join the sellers.

    Herd behaviour that can arise from informational differences:

    • The actions and judgments of investors that appear early can be crucial in determining which way the majority will decide.
    • The decision that investors herd on may well be incorrect.
    • With the arrival of new information, investors may eventually reverse their initial decisions, starting a herd in the opposite direction.

    When making your investment decisions, always remember that there is not always wisdom in joining the crowd.

    The MONEY® Network