We've all heard the term "herd behaviour", but before explaining how it relates to investors, its best to provide some background into the term.

Herd behaviour describes how a group acts together without any planning or logic behind their actions. Animals tend to exhibit herd behaviour when under attack from a predator.

If a group of zebras are running away from a lion, each additional zebra that joins the herd does so because they see a group running away from something; therefore they must join that same group. None of these new zebras attempt to verify the existence of the lion; they will merely do what all the other zebras are doing.

Back to the markets

So, how does this relate to the stock market? In strong bull or bear markets investors have a tendency to act like these zebras.

Consider the bull market leading up to the global financial crisis. During the middle part of the decade, nearly all stock markets around the world moved in one direction - upwards.

We can safely assume that a significant percentage of the people that bought equities during this time did so because they wanted a piece of the action.

People were making money from the stock market, drawing other people into investing, which further pushed stock prices higher, and so the cycle would just continue.

Now consider the bear market that followed. When stock markets were crashing throughout 2008, people were getting scared and selling off their shares.

The sell off depressed share prices, which caused more people to sell their shares, which therefore continued the cycle. In both the bull and bear markets mentioned above, consider how many investors assessed the merits of the stocks before buying or selling them.

People saw other people "running" into (or out of) stocks and simply decided to join the "herd". They were acting on emotion - specifically, the emotions of greed and fear.

The effects of herd behaviour

Not every person who invests does so because everyone else is doing it. Smart investors buy or sell stocks because they have done their homework before actually investing. These same investors would have noticed the massive run up in equity prices in late 2007 was driven in some part by herd behaviour.

They would have calculated that stocks were becoming overvalued, and so they sold their investments at the height of the bull market, thus locking in a nice profit.

Others would have noticed this and sold their investments as well. The process then cascaded until everyone was selling their investments, and the end result - the 2008 stock market crash.

How to avoid herd behaviour

Avoiding heard behaviour can be especially hard during periods of mass euphoria or panic. When stock markets are falling 50%, it is tempting to just throw in the towel and sell your own shares.

During these times, it is important to keep a level head when making investment decisions. A cardinal rule in share trading and investing is never act on emotion.

If you sold your shares in March 2009 because of fear, you would have missed out on the strong recovery that followed. When everyone is either buying or selling shares, assess whether buying or selling is the right thing for you to do.

Whether you follow Fundamental Analysis, Technical Analysis, dartboards or tarot cards, all your trading should be based on a system and not on emotion. That's the only true way to ensure you don't get trampled by the herd. Sign up for 7 days of free recommendations - click here.

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua