One of the most recent financial events would be the dot com bust. However, this was not the first time that such events have occurred and neither would it be the last. You must wonder how such catastrophes occur again and again.
The answer is simple; herd mentality. It is a human trait where individuals mimic the actions of larger groups, when individually most of these people would not necessarily make the same stock decision.
Here are two reasons why people follow the herd mentality.
- Social pressure
The social pressure to conform to a larger group may be tremendous and very powerful. This is because you live in a society and want to be accepted. Therefore, you follow a larger group without thinking whether it is logical or not.
It is most likely that you do not doubt the group when it comprises of so many individuals. Furthermore, even if you are doubtful, you may still follow the herd mentality considering that you may be unaware of certain things. This may especially occur when you do not have much experience.
Herding and investment bubbles
Herding behavior often results in volatilities in the stock market without much fundamental basis. An investment bubble is the result of an unprecedented surge in the prices of assets that are significantly higher than their actual value. The price increase continues until it reaches beyond economic rationale once there are no investors, the bubble commences to collapse and it may have far reaching effects.
The herd mentality is very strong. However, you must be aware and not follow this behavior as it may have severe results on your portfolio. Here are two ways in which following the herd mentality may have negative outcomes.
- Keeps you from new opportunities
Generally, investors and traders go against the market sentiments early during a boom and often earn huge returns on their investments. Because you may follow the herd mentality and refuse to evaluate trends because these are new, you may miss investing in these stocks when they are trading at their lowest prices. As a result, you fail to earn huge returns because you did not follow your gut and chose to follow the herd.
- Keeps you invested even with unfavorable returns
When you follow the herd mentality, you not only lose on investing at the lowest prices but miss out on exiting before the markets' peak. Because most investors do not sell their stocks, you also hold on to your investment. Therefore, when the market turns and there are not many buyers, you are stuck with your shares.
When you choose to invest in stocks, it is important to research thoroughly and develop your own informed opinions. By being aware about the market conditions and trends, you may avoid becoming a prey to the herd mentality.