Evidence of the Bandwagon Effect in the Stock Market
Stocks go up in value when they have more buyers than sellers. The increased demand allows sellers to wait for a better price while buyers compete. When stocks have more sellers than buyers, they go down. These moves gain so much momentum that prices rise or drop sharply in a short period of time, such as days or weeks. Buyers or sellers jumping on the bandwagon accelerate increase or decrease.
A blow-off top occurs when a stock has been rising steadily for several weeks or months and then suddenly shoots up quickly. On a stock chart, this creates a very steep climb that rises much more than any other places in the chart. This is evidence of the bandwagon effect. Investors who fear being left out of the winning stock start buying it because they think everyone else is, and not because of underlying fundamentals of the company that issued the stock. This is what Alan Greenspan was speaking about when he spoke of “irrational exuberance” in 1996. He was speaking of the markets in general, but the same principal applies to individual stocks. People start making irrational decisions to buy.
The bandwagon effect works in reverse. When the blow-off top hits its pinnacle, some sellers start taking profits. Other sellers may jump on the bandwagon sensing a reverse in trend. This sell-off accelerates when the people who bought the stock for irrational reasons begin to regret their purchases and fear losing their money. Evidence of this occurs in the sharp down trend that follows the blow-off top.
Initial Public Offering
Indications of the bandwagon effect sometimes come from IPOs. If the offering has been well publicized and investors sense that the stock could do very well, they may rush to get in on the first day of trading. The idea is that this is the cheapest the stock will ever be once it takes off. This can create demand that temporarily drives the stock up in price but it’s followed by a sell-off when cooler heads have time to value the stock based on the company’s profitability and prospects rather than an overabundance of enthusiasm from investors.
Intraday Peaks and Valleys
Further proof of the bandwagon effect occurs when a stock suddenly shoots up during the day for no apparent reason. If this sudden rise happens when there has been no news form the company or the financial media, it may be due to day traders trying to profit from a short-term trend. When these day traders take their profits and the stock suddenly drops back down near its opening price, this is evidence of the bandwagon effect.
- Reuters: Curing The Curse Of The Bandwagon Effect Before The Next Crisis
- TraderFeed: Bandwagon Effects in the Stock Market
- Slope of Hope: Blow-Off Top Rally Coming; BP Finance
- TradingSim: Oversold Market Condition
- The Federal Reserve Board: Remarks by Chairman Alan Greenspan
- EconTrader: Blow-Off Top
- TradingMarkets.com: A Simple Day Trading Strategy
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.