Herding bias in trading and investing is a situation where people buy assets that other people are buying. The strategy is commonly known as following the crowd.
It is termed as a herding because of how animals like cows gather in herds when they are grazing. In this article, we will look at what herding bias is in trading and investing, which are its risks and how to use it in your behalf.
Cows an other animals tend to stay in groups in most periods. Herding bias in trading and investing, as stated above, refers to a situation where people buy the same things.
A good example of this is what happened during the meme stock investing mania that saw companies like GameStop and AMC surge. At the time, most novice investors rushed to buy these stocks.
Herding bias is also common in large and sophisticated investors. This happens when many large investors buy the same stocks.
A good example of this is what happened in the past decade when most investors were buying companies like Apple, Amazon, Microsoft, and Meta Platforms (previously known as Facebook). Indeed, some studies have shown that most investors buy the same assets.
Another type of herding bias is what happened during the crypto boom that happened in 2021. At the time, most day traders were buying digital currencies like Bitcoin and Ethereum.
Herding bias is often identified herding instinct. The two are the same in that herding instinct is a term in sociology that is used to identify the tendency of traders to identify with and model their behaviour on other people who they identify with.
For example, most people in finance want to model their strategies on what successful investors like Ken Griffin and Warren Buffett do.
Herd bias happens in the financial market all the time. Historically, there have been several examples of this herd bias in the market. The most notable ones are:
A common question is whether the herding bias is a trading strategy or a bias. There are people who focus their trading strategy on following what the other traders are doing. In most cases, this strategy is often seen as momentum trading.
Momentum is a trading strategy that involves buying and selling financial assets when they are in a strong bullish trend. It is also known as trend-following. The same situation can happen when traders short assets whose prices are crashing.
A good example of this is what happened in early 2023 when investors dumped shares of Adani Enterprises after a stinging short-seller report. As the stock plunged, most existing investors dumped their shares and there were no buyers.
As We will explain below, herding bias has major risks that have cost investors billions of dollars. However, when done well, it can be an exciting trading strategy. Some of the benefits of this trading strategy are:
Herding bias has a number of cons, especially for people with no experience in the industry. Some of these cons are:
There are several strategies to use when trading using the herd bias strategy. Some of these strategies are:
This is a type of stop-loss that moves with the financial asset. As such, when there is a major reversal, you will still maintain the profits that you made.
A trailing stop-loss is better than the fixed stop loss because it moves in tandem with the fluctuation of the asset..
When there is a follow the crowd mentality, we often see a lot of volatility. You can mitigate this strategy by not leaving your trades open overnight.
Doing this will help you cushion yourself when there is a major issue when the markets close.
You should always do your research when there is a herding bias mentality issue. This research could involve reading and finding out why the stock is rising or falling.
Other risk-management strategies are having not using a lot of leverage and sizing your trades well.
We have seen how following the crowd can have two different meanings in trading, although very similar to each other.
The first is a strategy, with traders buying assets that are already going up or shorting those that are going down to take advantage of their momentum. And, as a strategy, it has its own analysis behind it.
Then there's the herding bias. As we have seen this is still following the decisions of the crowd, but in a less conscious and controlled way. And, because of that, with even more risk.