Herd behavior - rational or irrational

Herd behavior - is it rational or irrational? This is not an easy question to answer. Following the herd can be useful when there is significant market uncertainty. If you don't know what is the value of a security, follow the action of others. This could be called rational herding. Assuming that you believe the crowd has an information advantage. If you believe no one has an information advantage, then the best action is no action. 

Many define herding as following those who have already taken action without regard to your own private information. You desire to be a conformist relative to following your own views. This is irrational if your private information is correct or better than the action of others. Unfortunately, we are not always sure that our private information is correct. So the less certain we are about our views, the more likely we will or should follow the herd. 

Everyone acting at the same time to a given piece of new information may be spurious herding. If there is a news announcement and the market moves in one direction that could just represent a clustering of behavior. If the announcement occurs and you have a different interpretation of the data but you follow the actions of others, that would be considered herding. 

This is important because herding generates serial dependence in prices. Prices will trend. This will not happen all of the time, but it can repetitive enough to be exploited with models. However, herding may not be the focus of long-term trends. It may rather be more representative of short-term trends. Herds will break-up when enough investors follow their own private information, there is new public information, or a new herd is formed based on different expectations. Long-term trends are more likely the result of trends in fundamentals. 

Whenever a trend occurs it is always good to ask whether it is related to a trend in fundamentals, a clustering of new information, or investors just following the story and behavior of past investors. Good trend-following involves more than just looking at prices to understand the risks and potential for reversals.