Questions in behavioural economics - Why do we engage in herd behaviour?

Geoff Riley

25th June 2010

Most people would opt to dine in the restaurant with more people inside. Why? Is it because the restaurant is better? If the restaurants look identical, and you have never eaten there before, there is no reason to expect one to be better than the other, except that one has more customers. Of course, this element of human behaviour is sometimes sensible. It might well be the case that one restaurant is full because the food is better.

However, it is equally possible that, at the very beginning of the evening, one person chose restaurant B, at random. From that point onwards, any new potential diners who arrived followed him, making the assumption that he had some knowledge about the restaurants. In other words, they trusted a stranger, and selected where they should eat based on his random original decision.

This example may seem menial, but it relates to many of the most interesting phenomena in modern-day society, such as stock markets.

The FTSE 100 index plummeted from 6300 points, to 3500 points in less than a year in the middle of the recession. Of course, we can expect that recession will cause people to sell shares; but why, when GDP has shrunk by less than 10%, did share prices fall by 40%? The reason is herd behaviour. When investors realised that, having been entrusted with, in most cases, other peoples' money, the fear of 'going against the grain' caused them to sell.

Few people knew how deep the recession would be, how long it would last or which companies would fail. But most were confident that selling was the right thing to do. Naturally, as with the restaurant scenario, an initial decision to sell, leading to a small price fall, can lead to more selling, and more price falls. In many share trading offices, computers are programmed to join the herd at a set price. Recently, shares in Procter and Gamble fell by an unprecedented 35% within a minute. Why? The computers were programmed to sell at certain levels. Procter and Gamble had done nothing, but in a single minute, its business almost halved its value.

As can be seen, herd behaviour can cause humans to behave irrationally. Rather than making our own judgements when faced with decisions and problems, we resort to how others reacted. Why is this? Why do we behave in hers?

I think there is one main reason: fear. We see that other humans act in a certain way, and are afraid to act differently in case they were right. Another scenario:

You are in a class of 20 pupils. You all have to sit the same multiple choice maths paper. Having finished the paper, you hand in the question paper but hold on to your answers. The teacher then tells you that you can all look at everyone else's answers and change yours if you think they are wrong. The only rule is that you cannot talk. How many other people would have to have a different answer for you to change yours? If the first question had been '1+1' and you had written 2, but everyone else had written 1, would you change your answer? Would you assume that you had read the question wrong? You might. You would not have doubted yourself if you had not seen the other answers, but now, all of a sudden, you cannot decide whether to change. Why? Because there is no embarrassment in getting something wrong that 'everyone gets wrong', but there is if you're the only one to get it wrong.

Essentially, we fear being the fool or trying something new, but we feel safe if we join the crowd and do what everyone does.

How do we go about solving this problem? How do we prevent stock market 'boom and bust'?

Could we limit the amount of time people spend watching television, listening to the radio and surfing the net? We probably could, but there is a better way to solve the problem. Rather than limiting peoples' exposure to opinion, we should encourage people to listen to a greater variety of different opinions. Herd mentality poses no problems when there are numerous herds, all believing different things. It is a problem when there is only one herd. If we use open-source, global information, we allow people to hear multiple views and come to their own conclusions.

Convincing human beings not to act as herd animals is by no means an easy thing. We are fundamentally wired to look around us, and to observe others. Traditionally, one might argue that we should limit peoples' ability to receive information from others to reduce the likelihood of copying and therefore herd behaviour. Personally, I feel that countries where information and ideas can flow freely enable people to make educated decisions, without automatically inciting herd behaviour. It is the countries where information is limited and marshalled that herd mentality is most likely to develop. Whilst China's economy grows strongly, the herd is very much 'driving China in the right direction'. But what if a small set-back were to occur in China? Would the herd mentality resulting from governmental rules and regulations serve to help, or to hinder? It is difficult to say for sure, but I suspect that a small set-back might cause a large-scale spread of negativity. The government can attempt to limit this spread, but humans are inherently sociable, and information almost instantaneous. As such, freedom and openness are, in my opinion, the way to prevent herd behaviour.

Geoff Riley

Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.

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