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B. Venkatesh

PICTURE this. You want to buy shares of HDFC. Your fellow investors, however, feel that the stock will decline. You, therefore, decide to either short-sell the stock or refrain from placing a buy order. You later regret the decision because the stock eventually closed higher.

If you have had such an experience, don't be upset. You are, as any normal human being, prone to crowd behaviour. But what is crowd behaviour and why is it important in financial economics?

A crowd is as a group that holds a common belief. The study of crowd behaviour has helped social scientists explain events as diverse as the Holocaust in Nazi Germany to the 1987 stock market crash.

In the stock market, there are typically two sets of crowd — one that believes that a stock will go up and the other that believes that the stock will go down. Change in crowd behaviour leads to changes in stock prices. How?

Assume that there are 50 buyers and 50 sellers in a particular stock. What if another 10 investors enter the market and choose to buy the stock? The price will move up because demand will be higher than supply.

Now, suppose another 20 investors enter the market. Because the price has already moved up, there will be a natural tendency among these new entrants to also buy the stock. This will lead to a further rise in price.

Such a price rise could have an emotional bearing on the crowd that holds a negative view. Gradually investors in the negative crowd camp will start buying the stock. This will further increase demand for the stock, leading to even higher prices. At the extreme, such behaviour leads to a stock market boom. Market crashes happen when more people move from the positive camp to the negative.

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