Other investors’ decisions can start to look like information
Imagine an investor researching an investment and deciding that they are not convinced by it. They understand what it does, have considered the risks and initially decide not to invest.
Over the following weeks, however, they repeatedly see other people buying it. It appears in financial news, online discussions and conversations with friends. More investors seem confident about its prospects, and its popularity continues to grow.
The investor now faces an additional piece of information: other people are choosing the investment.
That observation can create a reasonable question. If so many people are buying, might they know something the investor does not?
This is one way that the behaviour of other investors can begin influencing an investment decision. The crowd does not simply create social pressure; its actions can appear to contain information.
What does herd behaviour mean in investing?
Herd behaviour in investing occurs when observing what other investors are doing influences someone’s own investment decision.
A useful distinction is whether knowledge of other people’s decisions changes what the investor would otherwise have done. Someone who originally intended not to invest might reconsider after seeing many others buying. Someone planning to hold an investment might become more inclined to sell after observing widespread selling.
This distinction appears in academic research into financial-market herding. A review by Sushil Bikhchandani and Sunil Sharma published by the International Monetary Fund describes herding in terms of investors being aware of and influenced by other investors’ actions. It distinguishes this from situations where many investors independently make similar decisions because they face similar information or circumstances. The IMF review examines the different mechanisms that can produce herd behaviour in financial markets.
This makes herd behaviour more specific than simply owning a popular investment. Thousands of investors can make the same choice without any individual investor copying another.
The important question is whether observing the crowd itself influences the decision.
Why can the crowd appear to know more than one investor?
Investment decisions are made under uncertainty. No individual investor has complete information about what will happen to a company, market or economy, and future investment returns cannot be known in advance.
Other people’s actions can therefore appear to offer clues.
If an investor sees many people buying an investment they had previously rejected, they may begin to wonder whether those investors have identified something they missed. The larger or more confident the crowd appears, the stronger that inference can become.
There can be some logic behind this response. Other investors may genuinely possess useful information or have interpreted publicly available information differently. The difficulty is that someone observing their actions usually cannot see the reasoning behind every decision.
One person may have carried out extensive research. Another may be following someone else. A third may be buying because the price has recently risen. Others may have completely different objectives, timeframes or attitudes towards risk.
From the outside, all of those decisions can look identical: people are buying.
The IMF review identifies information as one possible reason investors imitate others. If other investors might know something about an investment’s potential return, their actions can appear to reveal that information. It also identifies other possible influences, including incentives affecting professional investment managers and a preference for conformity.
The crowd can therefore become influential even when an investor does not know why the crowd is behaving as it is.
How independent judgement can gradually give way to the crowd
Herd behaviour can develop as observing other investors begins to influence a decision that was originally based on the investor’s own information.
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Reach an initial view
The investor researches an investment and initially decides not to invest.
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Observe other investors
They notice increasing numbers of people buying the investment or expressing confidence in it.
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Infer additional information
The investor begins to wonder whether other people know something that their own research has missed.
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Confidence in the original view weakens
The apparent agreement of the crowd makes the investor less certain about their initial assessment.
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The decision changes
The investor decides to buy, with the behaviour of other investors now forming part of the reason for doing so.
The investment itself does not necessarily need to change for the investor’s decision to change. Observing what other people are doing can become new information in its own right.
This process does not require the investor to abandon independent thought immediately. The influence of the crowd can build gradually as more people appear to reach the same conclusion.
Each additional person can seem to provide another piece of confirmation. Eventually, an investor may place more weight on what everyone else appears to believe than on the information that produced their original judgement.
This type of process is related to what researchers describe as an information cascade. Once people begin drawing information from earlier decisions, later participants can become increasingly influenced by what previous participants have done. The resulting agreement can then appear stronger than the independent information behind it actually is.
A popular investment is not necessarily an example of herd behaviour
Seeing many investors make the same decision does not prove that they are following one another.
Suppose a company announces results showing substantially higher profits than markets expected. Many investors independently assess the new information and decide that the company’s shares have become more attractive.
They may all begin buying at roughly the same time, but they do not necessarily need to observe one another before making that decision. Their similar behaviour can result from independently responding to the same announcement.
The same principle can apply when economic conditions change. For example, a significant change in interest rates could alter how investors assess different assets. Many people may respond to that information in similar ways without copying each other.
The academic literature sometimes distinguishes this from intentional herding using the term spurious herding. The IMF review explains that groups facing similar decisions and information can make similar choices without those choices being caused by observing one another. It also notes that distinguishing intentional from spurious herding in real financial-market data can be difficult because many factors can influence an investment decision simultaneously.
This distinction prevents popularity itself from being treated as evidence of behavioural bias.
Following the crowd can happen when markets rise or fall
Herd behaviour can operate in either direction.
During rising markets, investors may observe increasing numbers of people buying and interpret that behaviour as confidence. Popularity can then reinforce popularity: more people become interested partly because they can see that others are already interested.
This can overlap with performance chasing, but the two are not identical. Performance chasing occurs when recent strong returns become an important reason for investing. Herd behaviour instead concerns the influence of other investors’ decisions. Both influences can be present at the same time, but neither requires the other.
A similar process can occur when markets fall. Seeing widespread selling can make an investor question whether other market participants possess information that they have not considered. Selling by others can then become part of the reason for considering a sale themselves.
During periods of severe market stress, this social information can combine with uncertainty and visible losses. The separate guide to why investors panic when markets fall explores how those factors can create pressure to act.
Herding can therefore contribute to both buying and selling. What defines it is not the direction of the trade but the influence other people’s behaviour has on the decision.
The crowd can be right without making crowd-following reliable
It would be misleading to assume that following the crowd always produces a poor outcome.
A large group of investors can reach a conclusion that later proves correct. Other investors may have interpreted information accurately, and observing their actions may sometimes draw attention to something worth investigating.
Equally, making an independent decision does not make that decision correct. An investor can disagree with everyone else and still be wrong.
The difficulty is that popularity alone does not reveal the quality of the reasoning behind it.
If 10,000 investors are buying an investment, an observer can see the collective action but may know very little about why those investors are buying. Some may have researched the investment carefully. Some may be responding to recent performance. Some may be copying still other investors. Their financial circumstances and objectives may also be completely different.
Nor does widespread demand remove investment risk. The FCA explains that investment values can fall as well as rise and that returns are not guaranteed. The relationship between risk and return also does not provide a formula under which accepting greater risk guarantees greater returns. Its explanation of investment risk and returns provides further context.
The number of people making an investment therefore cannot, by itself, establish what return it will produce or whether the investment fits another person’s circumstances.
Separating popularity from the reason for an investment decision
The central issue with herd behaviour is not whether an investment is popular. It is how that popularity enters the investor’s reasoning.
Observing other people can provide useful information. It might draw attention to an investment, prompt further research or reveal that other investors interpret existing information differently.
But there is a difference between learning that many people have reached a conclusion and understanding the information that supports that conclusion.
This distinction becomes particularly important when the reasons behind other investors’ decisions are invisible. Someone may know that an investment is attracting considerable attention without knowing the objectives, research, risk tolerance or assumptions of the people buying it.
Popularity can also interact with other behavioural influences. If other investors appear to be making substantial gains, the situation can develop into the fear of being left behind explored in why investment FOMO can affect decisions. If rising prices themselves become the main attraction, the mechanism moves towards performance chasing. If confidence created by rising markets later turns into selling after prices fall, it can contribute to the pattern described in why investors buy high and sell low.
These behaviours can overlap, but separating them helps identify what is actually influencing the decision. With herd behaviour, the defining influence is the observation that other people are making a particular choice.
Conclusion
Investors can follow the crowd because other people’s decisions can appear to contain information. When many investors are making the same choice, an individual may reasonably wonder whether they know something that has been missed.
Herd behaviour becomes relevant when observing those choices changes the decision the investor would otherwise have made. That is different from many investors independently reaching the same conclusion after receiving the same information.
The crowd is not automatically wrong, just as an investor acting independently is not automatically right. The difficulty is that observing what other people are doing does not necessarily reveal why they are doing it or whether their reasons are relevant to another investor.
Understanding that distinction helps separate the popularity of an investment from the information and reasoning behind the decision to invest.
