Herd Behavior and Investment

TLDR

Investment decisions are often influenced by herd behavior, where managers imitate others and ignore private information, a practice that may be socially inefficient but can be rational for reputation concerns, challenging the classical view that decisions are made efficiently using all available information. This paper examines forces leading to herd behavior in investment and discusses applications of the model to corporate investment, the stock market, and firm decision making.

Abstract

This paper examines some of the forces that can lead to herd behavior in investment. Under certain circumstances, managers simply mimic the investment decisions of other managers, ignoring substantive private information. Although this behavior is inefficient from a social standpoint, it can be rational from the perspective of managers who are concerned about their reputations in the labor market. We discuss applications of the model to corporate investment, the stock market, and decision making within firms. (JEL 026, 522) A basic tenet of classical economic theory is that investment decisions reflect agents' rationally formed expectations; decisions are made using all available information in an efficient manner. A contrasting view is that investment is also driven by group psychology, which weakens the link between information and market outcomes. In The General Theory, John Maynard Keynes (1936, pp. 157-58) expresses skepticism about the ability and inclination of long-term to buck market trends and ensure efficient investment. In his view, investors may be reluctant to act according to their own information and beliefs, fearing that their contrarian behavior will damage their reputations as sensible decision makers: