Herd Mentality

Hi everyone welcome back! I took a little break from writing the last two weeks, but I'm happy to be back with a new entry on herd mentality!

So, by definition, what is herd mentality? Essentially, herd mentality is the idea behind how people will make decisions based on what the majority is doing. A famous economist, John Maynard Keynes, said that herding was a response to uncertainty and individuals' perception of their ignorance: people may follow the crowd because they think that the rest of the crowd is better informed. As a result of this, the behavior may cause exaggerated movements within the market, resulting in crashes and sharp rises. He famously compared the stock market to a beauty contest, stating that participants will try to guess which contestant that other contestants will deem the most beautiful, rather than choosing the one they personally find most attractive. Through this analogy, Keynes is trying to say that investors are not trying to pick the most valuable stocks, but instead try to predict which stocks others will favor. Once again, this goes along with the herd mentality theory.

Is herd mentality good or bad for the economy?

When is it a good thing?

Some common examples where herd mentality is seen every day are in simple things such as picking where to eat for dinner. If you are out on the street, and you see a restaurant with a large queue, full of people eating and seemingly enjoying their meal, you're more likely to go eat there than the deserted next-door restaurant, right? Even though you have never tried the food there before, you trust that it is a good restaurant due to other people choosing to eat there. We believe that the crowd signals a better quality of service, food, etc. This can benefit those restaurants with maintained popularity, advertising, and a good reputation within the area, however, those new up-and-coming businesses will struggle to get customers. Herd mentality can also aid market efficiency. In a market with a wide range of consumers and producers, each individual or company may possess different pieces of information or interpretations of data. If a single piece of information comes to light, e.g., an earnings announcement or geopolitical event, there will be some investors who act immediately, and some who wait for confirmation or validation from others. As those who reacted to actions come to light, it will become visible within the stock market. Other investors may see this as a signal of changing market conditions and decide to follow suit, changing their investment strategies accordingly. These responses may result in changes in asset prices. If the information for a particular asset is deemed positive, the demand for it may increase, causing its price to rise. Or if it is negative the opposite may occur. Via this process of herd behavior, information is quickly incorporated into asset prices. Assets are priced based on the collective wisdom and actions of market participants, reflecting the available information and expectations about future outcomes. Overall, herd behavior makes it easier for information to spread quickly through the financial markets, which improves resource allocation and price discovery.

However, some large consequences arise as a result of herd mentality.

One possible consequence is there may be a misallocation of resources. This is because investors and businesses may focus on the current popular trends or sectors as opposed to looking at long-term growth and revenue. There may also be a possible overreaction to certain news or information if everyone jumps on the same 'bandwagon' due to limited information. This can cause drastic shifts in market price and the level of demand and supply. This means prices for certain goods or services can jump up or down rapidly, having drastic negative effects on consumers and businesses, which can be difficult to reverse.

Aside from an economic point of view, psychologically, how does herd mentality explain our behaviour?

Social media has been a big driver of an increase in herd mentality since its rapid surge in popularity during the 21st century. It can manipulate what you want to purchase (I want it because everyone else has it), what you want to wear (I want to wear it because everyone else is wearing it), and even who you support (I don't like this person because everyone is hating on them). This links to many topics being discussed today with things such as cancel culture. We are sometimes unaware of how much our choices and beliefs are influenced each day. The majority of people will choose to stick with the crowd - it's safer, with less chance of rejection or being wrong. Many people, including myself, experience FOMO (Fear of missing out). This can cause impulsive decision-making as people are desperate to be a part of certain movements, events, etc. We tend to be desperate to be updated on the latest trends, news alerts, stock market changes, and our favorite celebrity's social status. But what is the reason for this? Some of it can be attributed to social influence. Essentially, human beings are very social creatures. We look to others around us to seek validation, guidance, and reassurance, particularly in uncertain situations. Human beings tend to choose to take shortcuts in their brains by siding with the majority rather than thinking critically about their decision. We tend to fall victim to confirmation bias, where we actively seek out information that fits with our beliefs as a form of self-assurance. This is why social media can be so damaging and dangerous. The algorithm of these websites studies what content we typically search, engage with, and follow. Therefore if we have a strong belief in something, our feed will be tailored around that belief and give the user a feeling that their belief is correct, even if it isn't. This allows misinformation to be spread and can be extremely harmful to society.

This is a topic I find very interesting and I hope you enjoyed reading it! Feel free to check out some of my other blogs :)