If you are sitting in a packed cinema enjoying a romantic movie with your partner and someone suddenly yells “fire” and runs out, the chances are other individuals may perceive this as a signal to also leave the cinema, even if they have not seen or confirmed the existence of a fire. This behavior can create a panic, leading to a stampede that will, needless to say, ruin your romantic evening. The scenario described is an example of herd behavior where individuals who are uncertain about the appropriate course of action, may follow the actions of others. Does this remind you of something that is just happening in some of the US banks facing a bank run after the collapse of the Silicon Valley Bank (SVB)?
Herd behavior is a natural human tendency that has evolved over the course of our evolution as a survival mechanism. In early human societies, living in groups provided protection and increased the chances of our survival. To put it in simple terms, Individuals who followed the behavior of the group had a better chance of survival than those who acted independently. This behavior has been reinforced over time through socialization and cultural learning. As individuals interact with others in their social groups, they learn to conform to group norms and follow the behavior of their peers. Additionally, herd behavior can be amplified by cognitive biases, such as the availability heuristic, where individuals make decisions based on easily available information, rather than considering all available evidence. In situations where information is scarce, individuals may follow the actions of others as a way to reduce the cognitive effort required to make a decision.
So herd behavior can be a rational response to uncertainty or incomplete information. In situations where individuals are unsure about the best course of action and swift decisions are required – like a fire in the cinema or a bank collapse, they may choose to follow the actions of a larger group, as they perceive it to be a more reliable signal of what the best course of action is. This is exactly what just happened in the collapse of the SVB bank that followed the media storm leading to a customer race against each other to pull money from the bank with more than $40 billion withdrawn suddenly in a classic bank run no one expected to see in 2023. A bank run occurs when large groups of depositors withdraw their money from a bank at the same time on fears that the bank will become insolvent. With more people withdrawing money, the bank uses up its cash reserves and ultimately ends up defaulting.
All fine until here, but while following the actions of others in a dangerous situation may seem like a rational response to uncertainty, herd behavior also has its downsides. It is one of the main drivers behind stock market bubbles, where investors follow the trend of buying a particular stock or asset, even if its price is significantly higher than its fundamental value. This behavior can lead to a price bubble, which eventually bursts, causing a significant market correction. We all know when your hairdresser or the mechanic tips you to buy a certain stock or an asset class, it’s about time you get out of it. In many Initial Public Offerings (IPOs) herd behavior is also present, where investors tend to invest in a newly listed stock simply because other investors are investing in it, without considering the fundamentals of the company. And let’s not forget the real estate market, where buyers tend to follow the trend of buying properties in a particular area, like a condo in MIami, leading to a surge in prices, which form bubbles that sooner or later burst.
Herd behavior and retirement saving
Herd behavior can also be observed in retirement saving decisions. For example, when individuals follow the investment decisions of their peers or the default investment option offered by their employer-sponsored plan, without considering their personal financial goals and risk tolerance. This can result in suboptimal investment decisions and may lead to individuals not achieving their retirement savings goals. That is why it’s essential for individuals to understand their personal financial goals and risk tolerance and make investment decisions that align with these factors. The same goes for contribution levels as the default rate is not optimal for all plan participants and similar can be said about ways of drawing down your savings. This is why it is important for employers to provide educational resources and tools that help workers make informed retirement saving decisions, rather than simply following the actions of others. Also taking independent financial advice can help us to better understand our unique financial situation and select an appropriate set of products and services to come to a desired result.
So it’s good to keep in mind, herd behavior is not always a rational behavior, as it can lead to suboptimal outcomes for individuals and society as a whole. In some cases, herd behavior can be a result of individuals following the actions of others without considering the available information and their own preferences or needs. As Charles MacKay nicely put it: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”