The need for rapid decision making as important news flashes on trading screens can put traders and investors in vulnerable situations, so they sometimes make themselves feel more secure by following the herd. While herding is not common when considered against the massive volume of trading that occurs on a daily basis, during event uncertainties in the financial markets it is more common for traders and investors to act as others have acted.
Herding behavior in the stock market can take three forms. Information-based herding happens when everyone reacts the same way to announced information. Reputation-based herding is caused by a respected investor or major trading house taking a specific trading stance. Compensation-based herding occurs when certain conditions prompt large institutional money managers to take profits, generally to protect fund earnings before year-end reporting. These behaviors create large volume in certain stocks or sectors that are popular institutional portfolio investments, prompting those watching to react quickly.
Herding behavior also can take place when traders notice a trade imbalance. When a stock has high volume, other traders make decisions to follow the herd or take a contrarian approach. A larger than usual number of sell or buy orders can be considered a sign that somebody knows something. Since the market moves fast on split-second decisions, and there isn't time to do research, unusual activity can prompt a trader to go with the herd just in case important news is behind the volume.
When an event or a trading imbalance occurs, fear can be part of the decision to go along with the herd. Traders fear losing money if they hold their stock position in spite of large sell volume. They also fear loss of opportunity to make money by ignoring large buy volume. This fear is not simply a trading choice, because if a trader misses too many buy or sell opportunities and loses too much money it can cause the loss of his job and possibly irreparable harm to his career. In many ways, it is better to act with the herd than to take the risk of being the only trader who didn't sell or buy in time.
The job of stock promoters is to work up enough buy interest in a stock to create herd psychology. Stock promotion is a greater factor in the penny stock market, where many of the companies are relatively unknown to the average investor. Because they tend to be more thinly traded than the well-known stocks, any buy volume can move the price of the stock significantly higher. Promoters play on investors' greed and fear of missing the stock that could be the big money-maker of their dreams.
Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.