Herd Instinct and Diffusion in Finance
Herd Instinct and Diffusion in Finance
https://www.investopedia.com/terms/h/herdinstinct.asp
Often in finance, investors follow what other investors seem to be doing, instead of their own analysis. They tend to buy at the top of a market rally and jump off the ship in a market sell-off. This mentality is distinguished by a lack of individual decision-making or introspection. The herd instinct, has started large, unfounded market rallies and sell-offs. This can also cause asset bubbles in financial market, such as the dotcom bubble of the late 1990s and early 2000s. An investment bubble forms when the price of an asset is driven above its actual intrinsic value, and continues to inflate until the price is greater than fundamental and economic rationality can allow. When investors stop buying at that high price, the bubble collapses.
Those who invest based on herding follow the diffusion model from chapter 19, in which each node switches from option A to option B if the fraction of their neighbors that chooses B is greater than the threshold value. We can apply this model to the economy. Option A is not investing, which is everyone’s starting state. Option B is investing in some particular company. The “neighbors” are other investors, and the threshold q is the amount of other investors that have invested divided by all investors. Each person who follows the herding instinct has their own threshold value, at which they determine that since so many people have invested, so should they. This means that financial markets are very likely to have low threshold values, since many investors follow their herd instinct. This also applies to selling shares. One can analyze financial markets and make better investment decisions, as they should only invest in companies because you can analyze their intrinsic value, rather than because many other people are investing.