Rational Vs. Irrational Herding

Herding behaviour in financial markets can be considered rational or irrational, and the two types of herding behaviour have different impacts on market behaviour. Rational herding is a phenomenon that occurs when investors collectively follow primary signals, facilitating efficient price discovery and reducing information acquisition costs. On the other hand, irrational herding is often caused by psychological biases, such as those resulting from social influences, which are the primary reason. In the aftermath, we also see phenomena like over-speculation, fear-induced sell-offs, and financial instability. Although herding can increase market efficiency in some situations, it often causes more harm than good when it becomes the primary driver of speculative bubbles and unexpected market downturns. One glaring example is the 2015 volatility of the Chinese Stock Market, where irrational herding fast-tracked the market’s rise before it crashed, thus revealing the capability of uninformed collective actions to cause harm. This chapter will examine the diversification of herding behaviour into both rational and irrational herding, along with their consequences for the market, which can be either beneficial or detrimental depending on the circumstances in which they occur.