Herding Bias: Why Following the Crowd Often Leads Off a Cliff

The urge to join is powerful. This is herding bias, and it has destroyed more wealth than almost any other behavioural tendency.

What Herding Bias Is#

Herding bias is the tendency to follow the behaviour of a larger group, particularly when facing uncertainty.^¹ In investing, this manifests as buying what others are buying (especially during euphoric markets) and selling what others are selling (especially during panics).

The psychological mechanism is social proof: we use others' behaviour as a signal for what we should do.^² When many people are making the same choice, it feels like validation that the choice is correct.

Herding is distinct from but related to FOMO (fear of missing out) - the anxiety that others are experiencing gains or opportunities that you are not.

The Psychology of Herding#

Evolutionary Origins#

Herding behaviour was adaptive for most of human history. If everyone in your tribe suddenly started running, you should run too - the cost of a false alarm (wasted energy) was far lower than the cost of ignoring a real threat (being eaten).^³

This heuristic - "if everyone else is doing it, there is probably a good reason" - served survival well in physical environments but fails in financial markets.

Information Cascades#

Herding intensifies through information cascades.^⁴ When early investors buy an asset, later investors interpret their buying as evidence of quality. This encourages more buying, which signals more quality, creating a self-reinforcing cycle.

The problem is that information cascades can be based on very little actual information. A few early adopters can trigger a cascade that grows far beyond what fundamentals justify.

Reputation Protection#

Professional investors often herd because career risk is asymmetric.^⁵ Underperforming while holding the same investments as everyone else is forgiven ("no one saw it coming"). Underperforming while holding different investments is career-threatening ("what were they thinking?").

This creates incentives to follow the crowd even when individual judgment suggests otherwise.

How Herding Affects Investment Decisions#

Buying at the Top#

The most destructive manifestation of herding is buying into bubbles. When asset prices rise, enthusiasm grows. Rising prices attract media attention, dinner party conversation, and new investors. This additional buying pushes prices higher, attracting more enthusiasm.

The investors who buy late in this cycle - after hearing about gains from others - often pay the highest prices and suffer the largest losses when the bubble deflates.

Historical examples:

• Dot-com bubble (1999-2000): Retail investors flooded into technology stocks just as valuations peaked
• US housing bubble (2006-2007): Home buying reached a frenzy just before the market collapsed
• Cryptocurrency mania (2017, 2021): Retail participation surged at or near price peaks

Selling at the Bottom#

Herding works both ways. During market panics, investors observe others selling and interpret this as a signal to sell. Fear becomes contagious.

The problem is that selling during panics locks in losses and often occurs at the worst possible prices. Markets typically recover, but investors who sold during the panic have exited.

Research on individual investor behaviour shows consistent patterns: net outflows from equity funds occur at market bottoms, and net inflows occur at market tops.^⁶

Sector and Theme Chasing#

Herding drives sector rotations as investors pile into whatever is currently popular:

• AI stocks when AI is in the news
• Clean energy during climate policy discussions
• Biotech during health crises

By the time a theme becomes widely popular, much of the potential gain has often been captured. Late-arriving herding investors frequently experience disappointing returns.

Social Media Amplification#

Modern herding is amplified by social media, where investment trends can go viral. Reddit forums, Twitter/X discussions, TikTok videos, and YouTube channels create rapid consensus around particular investments.

This can produce extreme examples of herding behaviour, with assets experiencing massive price swings based more on social momentum than fundamental value.

Evidence-Based Strategies to Counter Herding#

1. Develop an Investment Policy Statement#

A written investment plan established in advance provides an anchor against herding impulses.^⁷ The plan should specify:

• Asset allocation targets
• Rebalancing rules
• Criteria for adding or removing investments
• What would cause a change in strategy

When everyone else is buying the hot new thing, the plan reminds you that you have a strategy and this is not in it. When everyone else is panic selling, the plan reminds you to stay the course.

2. Use Contrarian Thinking#

When you feel the strongest urge to follow the crowd, pause and consider the contrarian position:^⁸

• "If everyone is buying, who is left to buy? Where will new buyers come from?"
• "If this investment is so obviously good, why is it still available at this price?"
• "If everyone is selling, are valuations becoming more attractive rather than less?"

Contrarian thinking does not mean automatically opposing the crowd. It means ensuring you have considered the possibility that the crowd is wrong.

3. Consider Valuation Metrics#

Herding often pushes prices away from fundamental value. Checking valuation metrics provides a reality check:

• Price-to-earnings ratios vs. historical averages
• Price-to-book ratios vs. comparable investments
• Yield comparisons across asset classes

Extreme valuations (high or low) are often symptoms of herding-driven prices. This does not mean the crowd is wrong immediately, but it signals elevated risk.

4. Implement a Waiting Period#

FOMO creates urgency: you need to buy now before missing out. This urgency is usually false. Markets will be open tomorrow, next week, and next year.

Implement a waiting period (e.g., 7-14 days) before making any investment decision driven by social signals. The delay allows emotional intensity to fade and more rational assessment to occur.

5. Diversify Systematically#

Diversification is the structural antidote to herding.^⁹ A diversified portfolio automatically has exposure to whatever is currently performing well, without requiring the investor to chase it.

If you maintain diversification through disciplined rebalancing, you will naturally sell some of what has risen (reducing bubble exposure) and buy some of what has fallen (increasing recovery exposure).

6. Limit Social Media Exposure#

Social media amplifies herding signals. Consider:

• Unfollowing accounts that promote specific investments
• Avoiding investment forums during periods of market excitement or panic
• Setting time limits on financial social media consumption

This is not about ignorance - you can stay informed through less emotionally charged sources - but about reducing exposure to herding triggers.

7. Track Sentiment as a Contrary Indicator#

Professional investors often use sentiment indicators as contrary signals:^¹⁰

• Extreme bullishness (everyone is optimistic) suggests caution
• Extreme bearishness (everyone is pessimistic) suggests opportunity

You can do the same informally by noting when everyone you know is excited about (or terrified of) the market. These extremes often coincide with turning points.

The FOMO Trap#

FOMO (fear of missing out) is herding's emotional engine. It creates the sense that:

• Others are getting rich while you are not
• The opportunity will disappear if you do not act now
• You are falling behind your peers

Recognising FOMO is the first step to resisting it. When you feel urgent pressure to invest in something popular, ask:

• "Would I want this investment if no one else was buying it?"
• "Am I responding to the investment's merits or to others' behaviour?"
• "What is my actual fear - missing a gain, or being left behind socially?"

FOMO is rarely a valid investment thesis. If FOMO is your primary motivation, that is a signal to wait.

When Herding Is Not Entirely Wrong#

Crowds are not always wrong. Markets aggregate information from many participants, and prices often reflect genuine value. The existence of trends does not mean every trend is a bubble.

The issue is not whether to ever invest in popular assets, but whether your investment decision is driven by:

• Independent analysis of value and risk, or
• Social signals that others are buying

The first is legitimate investing. The second is herding.

Recognising Herding in Yourself#

Warning signs that herding may be affecting your decisions:

• You feel urgency to invest in something because others are doing so
• Your investment ideas come primarily from social sources (friends, media, forums)
• You feel anxiety about missing gains others are experiencing
• You want to sell because you see others selling
• You feel more comfortable with an investment because it is popular
• You have not done independent analysis beyond reading what others think

Summary#

Herding bias leads investors to follow the crowd, buying when others buy (often at market peaks) and selling when others sell (often at market bottoms). This behaviour is driven by social proof, information cascades, and FOMO. Evidence-based countermeasures include: developing a written investment policy to anchor against impulses, using contrarian thinking to consider whether the crowd might be wrong, checking valuation metrics for signs of herding-driven prices, implementing waiting periods before acting on social signals, maintaining systematic diversification, limiting social media exposure during market extremes, and tracking sentiment as a potential contrary indicator. Recognising FOMO as an emotional state rather than an investment thesis is crucial to resisting herding impulses.

Sources#

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