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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is professor of globalisation and development at Oxford university and co-author of Terra Incognita: 100 Maps to Survive the Next 100 Years
From the US Capitol to Wall Street, the power of social media to mobilise crowds is evident everywhere. It has introduced a new risk to the effective functioning of markets as it has to politics, exposing the limitations of politicians and regulators to manage viral campaigns.
The recent price explosion in the stumbling GameStop was portrayed on the r/WallSteetBets sub-forum on the Reddit platform as a just redistribution that took gains from the pockets of “parasitic” hedge funds that had bet against the struggling US video games retailer into the hands of “ordinary” people.
But the GameStop surge also shows the extent to which financial markets are susceptible to the mobilisation of investment crowds on social media. Investors and policymakers urgently need to understand the implications.
Investor mania is an established topic in economics, but research by Valentina sem*nova and Julian Winkler at Oxford university reveals how interest in a stock can form on social media. Through hype and contagion, it then can underpin the retail investor bull runs we observed in GameStop and elsewhere.
We have tracked r/WallStreetBets’ rise from 2015. During last March’s stock market crash, users ardently advertised their purchasing of put options on the popular S&P 500 index — bets on a large stock market downturn.
Social contagion is a well-documented phenomenon: people adopt others’ behaviour, from smoking to product purchases
At the time, their size, relative to the S&P 500, meant any influence was small, and r/WallStreetBets was largely dismissed as a curiosity. However, as the forum exploded in size (it currently boasts 8.8m self-described “degenerates”), its influence has grown more pronounced.
Social contagion is a well-documented phenomenon: people adopt others’ behaviour, from smoking to product purchases. r/WallStreetBets was able to channel this into financial decision-making, attracting those with a particular taste for high-risk bets on stock-specific options that are often at odds with rational economic theory.
Users are encouraged to gamble, with redditors displaying their oft collapsing but occasionally ballooning trading losses and profits, galvanising their peers to adopt similar positions.
The likelihood of persuasion increases as an individual is exposed to more and more discussions on a given asset. It takes a while for interest in a given stock to take off, but once it does, it becomes a self-perpetuating force to be reckoned with.
Our text-based sentiment measures strongly suggest that r/WallStreetBets frequenters strive to adopt the directional positions of their peers.
In other words, they buy (or sell) a stock, not because of any fundamental pattern or news, but because other users also buy (or sell) the stock. This effect is especially large in bouts of selling, pointing to interesting psychological models of investor panic during a downturn.
Over 9,000 different stocks are discussed on the forum, but given these dynamics, only a handful, such as Tesla and GameStop, rise to prominence with potential to have an impact on the market.
Given this herd behaviour, it was just a matter of time for a situation like the GameStop frenzy to unfold. And given the dynamics of the social media investor platforms it is likely to happen again.
How to address this is now an urgent challenge for regulators. The champions of free markets, and the users, argue that the platforms allow the markets to work as intended and that hedge funds were caught making bad bets, which they otherwise would have got away with. Silencing the forum for the sake of market stability would be a draconian solution, and unlikely to endure. Anonymity on Reddit makes it harder to pursue market manipulation charges against individuals.
Few in the Biden administration would wish to use political capital defending Wall Street against a Redditor army. However, doing nothing is likely to create unacceptable risks which could threaten financial markets.
Fortunately, social contagion takes time to develop and is possible to track. This means the regulators need not be caught out. Trading limits should be tightened on stocks which display frenzied activity, preventing destabilising market moves. Margin requirements should be increased for stocks that are subject to retail investor herding.
Regulators need to act now to ensure that financial markets are properly capitalised and that this new market development does not provide a new source of systemic risk.
Video: How the GameStop short-sellers play | Charts that Count
This article draws on work by Valentina sem*nova and Julian Winkler
FAQs
Behavior in Crowds
Psychologists posit that a “group mind” can overtake a mob and embolden people to act in ways they would not individually, increasing the likelihood that situations become violent. Sporting events can also create herd behavior on a violent scale.
What is the main idea of herd behavior? ›
Herd behavior in humans is a social behavior that is caused when individuals subjugate their individual will, thoughts, and behaviors to the majority, the group, or herd. Herding does not require a leader; it just requires individuals coming together at the same time to act.
How does herd behavior affect the stock market? ›
Herd instinct, also known as herding, has a history of starting large, unfounded market rallies and sell-offs that are often based on a lack of fundamental support to justify either. Herd instinct is a significant driver of asset bubbles (and market crashes) in financial markets.
What would be the best example of herd behavior? ›
Herd behavior occurs in animals in herds, packs, bird flocks, fish schools and so on, as well as in humans. Voting, demonstrations, riots, general strikes, sporting events, religious gatherings, everyday decision-making, judgement and opinion-forming, are all forms of human-based herd behavior.
What is herd behavior commonlit answers? ›
[1]The term “herd behavior” comes from the behavior of animals in herds, particularly when they are in a dangerous situation such as escaping a predator. All of the animals band closely together in a group and, in panic mode, move together as a unit.
What is a real life example when you have seen herd behavior in action? ›
Herd behavior in humans is frequently observed at times of danger and panic; for example, a fire in a building often causes herd behavior, with people often suspending their individual reasoning and fleeing together in a pack.
Is herd behavior good or bad? ›
Herd mentality can have a powerful influence on people's behavior. In some cases, it can lead to positive outcomes, such as when a group comes together to achieve a common goal. But it can also have negative consequences, such as when people conform to harmful stereotypes or engage in risky behavior.
How does herd behavior influence decision making in everyday situations? ›
In certain circ*mstances, herd mentality can have positive effects. In situations where people have limited information or expertise, following the majority can lead to better outcomes, as the group's collective knowledge outweighs that of any single person.
What causes herd behavior? ›
Herd mentality is the tendency of people to follow the crowd and fit into society. What causes herd mentality? Fear, greed, and the human desire to belong to a social group can lead to herd mentality.
How to avoid herd behavior? ›
How do we stop regressing into herd mentality? Fostering independent thought and reflection can reduce the risk of sheeple behaviour. We need to ask questions, consider our options and educate ourselves in order to make well-informed decisions, even if that means running the risk of looking foolish.
There is a large weight of evidence of herd mentality bias in the financial markets. You can think about the dotcom bubble. Many dotcom companies did not have financially sound business models, but many investors bought into them because everyone else was buying into them.
What is the theory of herd behavior? ›
Basic theory of Herd Behavior
Herd Behavior means a state where the individuals are acting according to the actions of others rather than using their private signal (private information) to act.
What is herd behavior in marketing? ›
Herd Behavior is a fascinating aspect of consumer psychology that marketers often harness to drive their campaign strategies. But what is it, exactly? Simply put, it's the tendency for individuals to follow and mimic the actions of a larger group.
What are two positive ways to use herd mentality? ›
On the positive side, herd mentality can lead to increased information aggregation and improved decision making in certain situations 4. It can also create a sense of consensus and reduce perceived risk, which may attract investors and lead to market stability.
What is an example of herd behavior in finance? ›
Fundamentals-driven spurious herding out of equities could arise if, for example, interest rates suddenly rise and stocks become less attractive invest- ments. Investors under the changed circ*mstances may want to hold a smaller percentage of stocks in their portfolio.
What is the herd mentality and how does it affect people online? ›
Mob mentality -- also called herd or hive mentality -- is the inclination that some humans have to be part of a large group, often neglecting their individual feelings in the process, and adopting the behaviors and actions of the people around them.
How does herd behavior influence decision-making in everyday situations? ›
In certain circ*mstances, herd mentality can have positive effects. In situations where people have limited information or expertise, following the majority can lead to better outcomes, as the group's collective knowledge outweighs that of any single person.
What are the pros and cons of herd mentality? ›
It can also create a sense of consensus and reduce perceived risk, which may attract investors and lead to market stability. However, there are also drawbacks to herd mentality. It can result in the spread of rumors and misinformation, leading to the rapid propagation of false information 1.
Which of the following are examples of how herd behavior affects individuals? ›
One example of positive herd behavior is when individuals join a peaceful protest to raise awareness about an important cause. Negative effects can include individuals engaging in risky or dangerous behavior, such as participating in riots or panicking during a crisis.
