How Herding Leads to Market Bubbles

This is the fourth the Behavioral Finance and Macroeconomics series. We will explore the effect behavior has on markets and the economy as a whole--and how advisors who understand this relationship can work more effectively with their clients. (Access previous articles here.)

In the previous article, we discussed the shortcomings of a concept in traditional economics called Homo economicus or Rational Economic Man. We reviewed the idea that humans act irrationally, and that irrational behavior can trigger market bubbles, recessions and crashes. Today we'll discuss how the behavior of herding can lead to speculative bubbles.

Herding Defined When faced with uncertainty, people often copy the behavior of others. The stock market provides a great example. In fact, the behavior of crowds is often what causes large amounts of volatility in the stock markets--both on the upside and on the downside--because everyone wants to get in or out at the same time.

During times like the tech stock bubble of the late 1990s or the real estate bubble of the 2000s, for example, investors followed the behavior of other people they believe to be "industry experts" or people deemed prescient by the financial media. This type of behavior is called herding. In these cases, herding behavior caused massive inflows into particular asset classes, creating a tsunami-like effect.

Herding is a reactive phenomenon--it's not something that people contemplate to any great degree. When investors herd, they override their common sense and just want to "get in" or "get out" so they don’t get left behind.

There is a term to describe this classic herding behavior: FOMO, or fear of missing out. As others make money, the investors who are not participating follow the crowd because they feel their economic status will fall relative to those who are participating. This behavior causes even more of the same behavior, and bubbles begin to form causing irrational asset prices. (A bubble occurs when an increase in the price of an asset deviates from its fundamental or real value in a significant way.)

What Advisors Can Do It is critical, therefore, that advisors recognize when herding is happening both in the market and with their clients.

One of the best and easiest ways to guard against getting caught up in herding is to pay attention to valuations. Simple metrics such as price/earnings ratios and the like will often reveal an overvalued bubble situation. Some people choose to invest anyway, even when they know stocks are overvalued. And then the bubble pops, and then they say, "I knew it," which leads to another bias--hindsight. But we'll leave that bias for another article!

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.