New on FinoLib · Volume III: Finance Encyclopedia
I have added a new article to FinoLib, my finance education website: Herding Behavior and Mental Accounting in Finance Explained, part of Volume III: Finance Encyclopedia. This page gives you the core of the topic in expert but plain language; the full article goes much deeper.
6.5 Herding Behavior
The idea in plain words
Herding means following the crowd instead of your own analysis. It can make sense for each person on their own, through informational cascades, where each person assumes earlier people knew something, or through career worries, since it is safer to be wrong with everyone. But the crowd’s confidence may then rest on just a handful of early signals.
Key points
■In the cascade model, two early buyers with 70%-reliable signals make every later investor buy, whatever they see.
■Managers herd to protect reputations: being wrong with everyone costs less than being wrong alone.
■Cascades are fragile because one credible public signal can reverse them.
A closer look
Herding is following the actions of a larger group instead of one’s own analysis, even when one’s private information points elsewhere. It is a direct behavioral contributor to the bubble mechanics traced in Capital Markets Part 10: as prices rise and more participants join, each new buyer is influenced less by independent analysis and more by seeing everyone else buy, which reinforces the momentum driving the herd.
Decision rule
Before buying anything that has risen sharply, separate what you know independently from what you are inferring from other people’s buying. If the case disappears when you delete the second category (price momentum, fund flows, social-media attention, “everyone owns it”), you are probably in a cascade, so size the position so that a 50% fall would not change your plans. Ignore this rule for systematic momentum strategies that are diversified, rule-based and sized in advance; they harvest the pattern deliberately instead of joining it late.
The costliest mistake
Joining late. The price path is the same for everyone; the entry point is not. If an asset rises from $100 to $200 and falls back to $100, the early buyer is back to even, while the buyer who joined at $200 has lost 100 ÷ 200 − 1 = −50% and now needs a 100% gain to recover (Part 6.3: Anchoring). Herd buying is concentrated near the top by construction, because the crowd is largest when the evidence from other people’s buying looks strongest. Apply the signal-separation test before the purchase, not after.
Recap
Herding can be rational for each person, through informational cascades and career concerns, yet leaves the crowd resting on a few early signals and prone to sudden reversals. Separate your own information from what you infer from others’ buying, and size positions so that a late entry cannot do lasting damage.
6.6 Mental Accounting
The idea in plain words
Mental accounting means treating money differently depending on where it came from or what it is labeled for, even though money is the same everywhere. How often you check an account also matters. Checking often, combined with the pain of losses, can make good long-term assets feel bad. Defaults, on the other hand, use inertia for good: people tend to stay with whatever was set up for them.
Key points
■Myopic loss aversion: the equity premium fits prospect theory if investors evaluate portfolios about once a year (Benartzi and Thaler, 1995).
■Automatic 401(k) enrollment lifted participation to 86% from 37% at one large employer; 71% stayed at the default rate and fund.
■Section 414A now requires automatic enrollment, starting at 3% to 10% of pay, in most new 401(k) and 403(b) plans.
Decision rule
Treat all your money as one balance sheet when deciding what to pay off or invest, and use labels only for self-control. If you hold cash earning less than the rate on a debt you carry, use the cash to pay the debt, keeping only an emergency buffer. Accept automatic 401(k) enrollment, then raise the rate at least to the level that captures the full employer match. Review long-term portfolios on a fixed, infrequent schedule, quarterly or yearly.
The costliest mistake
Stopping at the default contribution rate when the employer match goes higher. Take an employee earning $60,000 whose employer matches 50% of contributions up to 6% of pay, the design at the company Madrian and Shea studied. Contributing the 3% default instead of 6% forfeits 0.5 × 3% × $60,000 = $900 of employer money a year. Over 30 years at an assumed 5% real return, $900 a year grows to $900 × (1.05^30 − 1) ÷ 0.05 ≈ $59,795 in today’s dollars, all of it money the employer was offering to pay.
What the full article covers
In the full article I take you through these sections:
■6.5 Herding Behavior
■6.6 Mental Accounting
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Herding Behavior and Mental Accounting in Finance Explained, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance