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Chapter 6 Bandwagon Effect (Following the herd)

The bandwagon effect is a psychological phenomenon in which people tend to do something mainly because some other people are doing it, regardless of their own views, which they generally tend to place at the side. This phenomenon is also commonly seen in financial markets more so during bull markets and the growth of asset bubbles.

Trading psychology is significantly influenced by the bandwagon effect. Any trader tends to feel more confident when he gets to know there are many traders who share the same view as his.

Traders fear being left out of the stock as they see a sudden spurt in the stock prices; instead of doing a thorough analysis of the company, they start buying the stock as they believe everyone else is doing the same. Similarly, a fall in the market can trigger a sell-off by the majority, which tempts others to “jump on the bandwagon” and trade similarly. Anyone who trades in such a compulsive manner is being influenced by the bandwagon effect. Trading in such a way on a regular basis could lead to major losses.

Initial public offerings during the current bull markets are also a notable example of the bandwagon effect in practice. The company’s IPO announcement often generates huge interest among the retail investors and if the investor estimates that there is large demand and there are many people he knows are applying for the IPO offering, he too rushes ahead to apply without much research about the company.

Bandwagon effect in markets and why traders tend to lose money

The bandwagon effect prevents traders to think in a rational manner by clouding their thought process and judgment letting traders get influenced by the behavior of others. Many traders like to follow the crowd, not performing their own analysis and ending up with huge losses. Some traders keenly track the actions of large funds or renowned investors in the financial markets and trade solely based on such information.

For instance in the above chart of Jaiprakash Associates when news broke out that a prominent investor had purchased the stock, there were many traders who blindly rushed to purchase the stock, they lacked the conviction nor did they put any amount of efforts to research about the company, the stock rallied a bit only to retrace the entire rally in the next few days, resulting in huge losses for the traders who ended up buying the stock at the top.

Strategies adopted to overcome bandwagon effect

Trade based on your analysis, ignoring the voice of the masses.

Taking contrarian trades once we have identified bandwagon effect in action.

Avoid reading market commentary and news while trading which could cloud your judgment.

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