“Men, it has been well said, think in herds”, Charles Mackay once said.
Herd behaviour is common in the stock markets. In the stock market, herding behavior is irrational and is driven by emotion—greed in the bubbles, fear in the crashes. Individual investors join the crowd of others in a rush to get in or out of the market. When the market is rising, people who are not invested are driven by greed and want to enter the market to make money as well. When the market is falling, people flee out of the stock market, out of fear. This is a perfect example of herd behaviour.
A famous experiment by Muzafer Sherif conducted in 1937 shows the herd behaviour succinctly. A group of people was asked to sit in a darkened room and observe a point of light through a small hole. They were told that the light would move and asked to estimate the extent of the movement. In actual fact, the light did not move at all, but when the subjects were later placed in discussion grounds, all agreed that movement had occurred and discussed only by how much they moved. When subsequently questioned, none appeared to be aware of any group influence.
The proper way to invest is to be fearful when others are greedy and be greedy when others are fearful. Buy during a market crash and sell at the peak of the euphoria and you won’t go wrong. Yes, it’s difficult to sell at the peak but we can always sell around the peak when we sense the euphoria and when the P/E ratios are shooting through the roof.