Herd Mentality in investment
In class, we talked about how people tend to follow the beliefs of the crowd instead of making their own rational decisions. This decision-overriding factor of the crowd, or herd mentality, has become so pervasive in our lives that we need to consider if such information cascade is beneficial or detrimental to our lives.
This idea is manifested in the finance industry, especially when there is uncertainty in the market. There are a lot of instances in history that demonstrated that herd mentality can go wrong. One famous one is The Dotcom Herd in the 1990s, where huge amount of capitals were poured into the internet-based companies by the venture capitalists and the private investors as they speculate the potential boom of the whole industry. Even though some of these venture capitalists have a lot of experience in finance and they were able to detect how some of these companies did not have financially sound business models, they gave in to the social pressure of conformity and still invested their money, perhaps drawing assurance from the fact that many others were also doing so.
Herd mentality is an especially hurtful investment strategy, since it involves investors constantly buying and selling their investment assets to pursue new trends, which constantly involves transaction costs which further erodes the any available returns. The idea of time-lag is another reason why herd mentality is a poor investment strategy, since by the time an investor heard of the newest trend in the market, many others might have already heard of it and probably have taken advantage of it. Hence, herd mentality may not yield profit-maximizing result and those who enter too late certainly have the potential to lose money.
Apart from creating financial bubbles, herd mentality can also potentially lead to missed investment opportunities. Nobody could have ever thought that Apple would become such a successful company with its stock worth more than $100/share today. In this case, nobody in the herd has the perfect knowledge or vision to forecast the future, and since any investment deviations from the current norm may be viewed as risky by the social norm, the lost investment opportunity is precisely another reason why herd mentality is bad for investment decisions. While market can be wrong,
In conclusion, modern investment is based as much as logic as as on emotions. An investor should not jump into the investment bandwagon and follow the trend when making investment decisions, but conduct his own industrial research.
http://www.telegraph.co.uk/finance/personalfinance/investing/shares-and-stock-tips/8129968/Herd-mentality-costs-investors-dear.html