Herd Behavior and Investment

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: