Behavioral finance FAQ / Glossary (Bandwagon)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Bandwagon effect, fallacy

01/1i,11i + see (economic) sector,
fad, contagion,
rotation, trend
following, crowd, momentum

Dragged by the most popular locomotive.

In social psychology

The bandwagon effect is a collective phenomenon in
which a growing majority of people
adopt the same
behavior.

More and more people imitate the majority of others, for good or bad
reasons, making that majority grow. The process unwinds as follows:

Many people join the initiators / leaders (locomotives) who

   started the train of a new social trend, once they see that it reaches

enough momentum / popularity.

After jumping onto the coal wagon, those newcomers add their own
   fuel to the engine.

A collective overreaction (see that word), and sometimes illusion, is
then at play

Behavioral reflex, emotion, or cognition?

Fear to be left out in the cold on the station platform?

This phenomenon can be called the bandwagon fallacy
aka "tyranny of the majority"
by which people feel unsafe or uncomfortable
if they do not follow the crowd
.

Most people get in the game because of a nearly automatic reflex (more
precisely an immediate
emotional reaction) in the form of a contagion /
a mimicry phenomenon akin to herding, groupthink, peer pressure...
(see those notions)


Also, when they do the same things as most others do, they often adjust their
own beliefs on the "dominant beliefs" (beliefs shared by that majority).

In such cases the cognitive effect can follow the (emotional) behavior instead
of preceding it.

Bandwagon effect in stock markets

Crowding the market train
and looking for the leftovers in the dining car.


In stock markets, the bandwagon effect refers either to investors or to assets.
It describes:

The arrival on the market of new trend
   followers
(see that phrase)

  And even more typically, the momentum

     extension to a larger number of stocks than
     the bellwether ones.

That phenomenon spreads like an oil spill and covers progressively a whole
economic sector, or even the whole market.

Therefore a salient aspect is the price rise or fall of secondary
stocks
that share
some of the leading stocks' traits:
same type of industry, of business model, of management...

This is because, in that phase, investors who jump into the train see
that the best seats are already taken and the best food in the dining
car has already been gulped down.

They could leave the vehicle but the impulse is too strong, they

prefer to take less appealing places and eat the leftovers.

By doing so they drag inferior stocks, but with some similar traits,
in their turn into the trend (see rotation).

Which stocks are dragged into the ride?

Seen from a distance, those stocks look like brothers.

This "pulling you / follow me" effect works often on stocks of firms
that:

Belong to the same industry than the leader(s): see rotation.

Or have activities directly or indirectly linked to that company or
    sector

Or belong to the same stock behavior category, for example

cyclical vs. defensive, small caps vs. big caps (see profile,
rotation)

Or have similar management practices, or a similar business
    model,

Or operate in the same geographical locations,

Or are subject to any other common key factor

(interest rates, energy price, social fashions...),

Or even, this is anecdotal, have a name (*) that is either close to
    the
leader's one, or that makes think of a similar activity  (errore

humanum est ;-).

Or even that have no relation at all:

A rise in a stock sector can spread to the whole stock
market
,
as was the case in the "dotcom bubble".

(*) Anecdotally, fashions and dress codes are seen in the way people
     name their companies
.

Some prefixes, suffixes or other linguistic traits can become suddenly
trendy.

Branding is a science, even for financial assets.

Also some studies have found that stocks with an easy to pronounce
name raise more investor interest than those with more complicated
names.

Why does such a market contagion happen?

Increased sympathy with the other travelers.

This phenomenon can happen for good / rational or bad / illusory reasons.

A bandwagon effect might:

Rational train?

Either signal that people realize that those stocks had
   hidden qualities
  / defects.

They discover good or bad prospects they overlooked or
misunderstood until now.

They see also that those stocks might, in some degree, benefit,
or suffer from the same general economic factors than the
leaders
.


Wild train?

Or, on the other hand, signal a fad .


In that case, on further analysis (but who analyzes fads?), the
fundamental situations and prospects of those diverse stocks will
appear more different from one another and from the market star
than what "followers" thought.


Even so there might be some rationality in joining a fad to
take advantage of it ...but by risking to stay stuck with those
stocks
the day the illusion evaporates and the train crashes
into a cow stranded on the rails.

As this phenomenon is rather common in some asset markets such as
stock markets, it is said that
stocks often rise or fall
"in sympathy" with others that are considered to have some
family ties.

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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