Study Notes

What is herd behaviour and when can it occur in economics and finance?

A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 24 Jul 2023

Herd behaviour is a phenomenon in which individuals make decisions based on the actions of others, rather than on their own independent analysis. It occurs when people act in a group collectively without centralised direction and is very common in a number of economics and financial contexts.

Herd behaviour is often seen by consumer responses to the launches of new products especially those that generate a huge response on social media.

Herd behaviour can occur in various economic and financial situations, and it is driven by psychological and social factors.

Some key examples of how herd behaviour manifests in economics and finance are:

  1. Financial Markets: In financial markets, herd behaviour can lead to asset bubbles and speculative bubbles. When a group of investors starts buying a particular asset (e.g., stocks, property, cryptocurrencies) due to positive price movements or hype, others may follow suit without thoroughly evaluating the asset's true value. This can drive prices further upward, leading to a bubble that eventually bursts when market sentiment shifts.
  2. Investment Decisions: Individual investors may follow the investment decisions of well-known or successful investors, believing that these individuals possess superior knowledge or insights. This can lead to herding into specific stocks or investment strategies, even if they may not align with an individual's risk profile or long-term financial goals.
  3. Bank Runs: In the commercial banking sector, herd behaviour can lead to bank runs. When some depositors start withdrawing their funds (savings deposits) from a bank due to fear of its stability, others may follow suit out of concern for losing their money. This mass withdrawal can trigger a self-fulfilling prophecy, causing the bank to face liquidity problems and possibly collapse.
  4. Consumer Behaviour: Herd behaviour can also influence consumer choices. When a product or brand gains popularity and becomes a social trend, others may start buying it just to be part of the trend, even if they don't necessarily need or prefer the product.
  5. Economic Policy: Governments and policymakers can also exhibit herd behaviour. If one country adopts a particular economic policy that seems successful, other countries may feel pressured to implement similar policies without considering their unique economic conditions or potential risks.
In economics, herd behavior can occur when investors make investment decisions based on the actions of other investors.

Causes of Herd Behaviour:

  • Information Cascades: The initial actions of a few individuals can create an information cascade, where others follow based on the belief that those before them possess superior knowledge or insight.
  • Uncertainty and Fears: In times of uncertainty or crisis, people may seek safety in numbers, assuming that the collective decision is more likely to be correct.
  • Social Influence: People are influenced by the behavior and choices of their peers, which can reinforce herd behavior.
  • Behavioural Biases: Cognitive biases, such as the fear of missing out (FOMO) or the desire for conformity, can also contribute to herd behaviour.

Herding behavior can lead to market inefficiencies, increased volatility, and suboptimal decision-making. In extreme cases, it can result in systemic risks and financial instability. Recognising and understanding herd behaviour is essential for policymakers, investors, and regulators to mitigate its negative impacts and foster more rational decision-making processes.

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