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“Following the Herd” Mentality

Written By Brian McKinney, CFP® June 12, 2020

Herding refers to the instinctive habit of people to imitate the financial behavior of a majority. Herding is based on the idea that people feel most comfortable following the crowd and tend to assume that the consensus view is the correct one.

In financial markets, this takes place when investors believe others to be better informed than themselves and follow them almost blindly, disregarding their own information and market fundamentals.

In investing, as it is in life, the value of something is often very difficult to determine. In 1st century BC, Publilius Syrus wrote: “Something is only worth what someone is willing to pay for it.”

Birth of the Herd Mentality

No better example of this exists than what occurred during the mid-1600s in Holland. Coined “tulipmania,” the Dutch tulip bulb market bubble was one of the most famous market bubbles and crashes of all time. Intense speculation drove the value of tulip bulbs to extremes. At the height of the market, the rarest tulip bulbs traded for as much as six times the average person’s annual salary. As the price continued to skyrocket, people thought the price would never stop rising. They continued to invest in tulips believing they could sell them at a higher price tomorrow. After tulips became so expensive, the cost of a single bulb exceeded that of an average home, the price collapsed, and many investors went bankrupt.

Due to extensive research in the field of behavioral finance, we now have a term to describe this irrational behavior: herding. Other well-known herd behavior-driven market crashes include the Roaring 20s, the dot-com bubble, and the housing bubble.