One of the first written accounts that linked economic bubbles to herding was in Charles Mackay’s 1841 study of crowd psychology Extraordinary Popular Delusions and the Madness of Crowds.

Mackay described economic bubbles as an example of the ‘madness of crowds’, referencing the Dutch tulip mania of the early 17th century. 

During the Dutch Golden Age, the contract prices for tulips reached extraordinarily high levels, only to dramatically collapse in February 1637. This is considered the first recorded speculative bubble.

Identifying herd mentality bias in trading

According to the International Monetary Fund (IMF), there are three key reasons traders and investors are influenced by their herd instincts. 

And while herding can occasionally have a positive outcome, the underlying method of ignoring value could have detrimental effects.

A more recent example would be the dotcom bubble of the late 1990s and early 2000s. During the bubble, people frantically started investing in US internet-related technology companies, irrespective of these companies’ fundamentals. As a result, the prices of tech stocks spiked dramatically and then later crashed.

Consequences of herd mentality

Herding can be a case of collective irrationality, but that does not necessarily mean that traders cannot use it. If a trader thinks they are able to identify when a market is in a speculative bubble due to herding, then they can use this in their decision-making process. 

During the 2021 GameStop bubble some traders recognised that herding was contributing to the rise in the GameStop share prices, and used this knowledge to trade the bull run, whilst being aware that it was a bubble.

Additionally, sometimes, what may seem like herd mentality, with countless traders making the same choices and driving up the price, may just be an example of market sentiment. 

Market sentiment is the general tone of investors towards a particular security. Herd mentality is often conflated with market sentiment at times. But to separate the two, one is a general tone of the market, whereas the other is an instance of countless people rushing into a market purely because others are. 

Avoiding herd bias

Biases are psychologically hardwired into us, however, there are five strategies a trader could consider that can help to avoid them:

• Switch off autopilot

It could be useful to stop and take the time to consider your goals before you begin trading. This could include reviewing whether the underlying asset has inherent value that matches the quantity of orders. Once you are aware of herding they can look at securities with a greater level of scrutiny. 

• Form your own opinion

In human rationale, people will make decisions based on a justification (regardless of whether this justification is grounded). When someone falls prey to herd behaviour they may justify their decisions based on the fact that others are doing the same. 

Basing your decisions on your own opinions and applying a level of scrutiny to your decision making that could help you potentially avoid herding altogether. Try asking yourself – Why are you making this decision? Being aware will naturally lead to better-informed decisions.

• Dedicate time for decisions

When making decisions in time-critical environments, such as trying to catch the start of a trend in the markets, you may be more likely to copy herd behaviour if everyone seems to be piling into a market. However, just because everyone else appears to be acting fast, does not mean that it is the best strategy. 

Consider taking time to assess whether buying into a market suits your strategy. Even if this risks being behind the curve, it is all part of the discipline and could help you avoid buying into fads. 

• Remember that stress could affect decision-making

Due to the detrimental effects stress can have on the human brain, people are more likely to give in to herding pressures when they’re in a stressful situation. It is a way of decision making that attempts to alleviate any further stress. As the markets can be extremely stressful, you may want to avoid letting that cloud your decision making. 

• Be willing to follow your own path as a trader

You could be more likely to justify an investment decision if others are doing it. Similarly, a decision can seem initially unappealing if you’re the only person supporting it. It’s the obvious thought “if I’m the only one thinking it, I must be wrong”. Following your own path as a trader means being confident in your trading strategy.

Conclusion

Herd mentality bias is the rationalisation that a course of action is the correct one because numerous other people are doing it. In trading, this can take the form of panic buying or the formation of financial bubbles. 

While there are ways in which traders can use this bias to their advantage, they may also want to ensure they are aware of and know how to avoid it. Methods of avoiding the herd bias could include taking time to form their own opinion ensuring that they’re not making decisions under stress.