Overcoming the Herd Instinct in Markets

Ever walked into a mall and saw heaps of people gathered into lines that stretch as far as the eye could see? You have no idea what’s going on, but for some inextricable reason you feel compelled to join the back of the line too and patiently await for this mysterious artefact to reveal itself. Hopefully something or someone turns up?

If you did, you just succumbed to the lure of the herd and fallen into perhaps one of the most common investor behavioural biases. Most daily examples of herding behaviour can be completely innocuous whether you’re strolling through your neighbourhood mall or adopting the latest trends. But as seen throughout history, extreme instances of herding in markets can significantly distort prices, lead to asset bubbles and even cause recessions.

From Tulipmania that gripped 17th century Netherlands, the dotcom bubble in the early 2000s as well as the subprime mortgage crisis during the 2008-GFC, history has shown that investors are willing to suspend disbelief when market euphoria swells to reach delirious highs. This is prevalent especially during bullish market conditions and when there is abundant liquidity in the system.

Go with the Flow? Not Really…

As social creatures, people have a sense of safety in numbers. There is just a collective reassurance that comes with conforming to the wisdom of the crowd especially when navigating the treacherous peaks and slopes of markets.

But if you take a closer look at just who is behind the trading desk, you may realise that that there isn’t anyone after all. The underlying reality of investing in stock markets today is that most trading are done by machine and algo traders who profit from short-term fluctuation in prices and ignore fundamental analysis. According to reports, 80% of daily moves in the US stock market are machine-led. In 2017, the global algorithmic trading market was valued at US$ 9,297.24 million and is projected to exhibit compound annual growth rate (CAGR) of 10.1% over the forecast period (2018 – 2026).

Behind each market plunge is a digital herd of trading bots programmed to buy and sell based on pre-determined formulas and models. This ignites a ‘flash crash’ like that seen in 2010 when the Dow Jones Index lost close to 1,000 points in mere minutes. The S&P 500, Dow Jones industrial average and Nasdaq collectively lost $1 trillion. But in 36 minutes, the rout was all over and markets rapidly recouped back its losses.

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