The bandwagon effect is the tendency of people to take certain actions or arrive at a conclusion primarily because other people are doing so. The phenomenon is observed in various fields, such as economics, politics, and psychology. Financial markets are no different.
The bandwagon effect works through a self-reinforcing mechanism. It expands using positive feedback loops, which means that the effect becomes stronger as more people join.
The Bandwagon Effect in Economics
It is important to understand how the bandwagon effect is described in economics because it illustrates the magnitude of the effect.
Gary Becker, a well-known economist from the University of Chicago, purported that the bandwagon effect is powerful enough to flip the demand curve to be upward sloping.
A typical demand curve is downward sloping, which means as prices rise, the demand falls. However, as Becker posits, an upward sloping would imply that even as prices rise, the demand rises. The figure below illustrates the two demand curves.
The Bandwagon Effect in Financial Markets
The bandwagon effect works in two ways in the financial markets:
1. Price bubbles
Price bubbles often happen in financial markets wherein the price for a particularly popular security keeps on rising. The price can rise beyond a point that would be warranted by the fundamentals, causing the security to be highly overvalued. It happens because many investors line up to buy the security bidding up the price, which in return attracts more investors.
2. Liquidity holes
In case of unexpected news or events, market participants tend to halt trading activity until the situation becomes clear. It reduces the number of buyers and sellers in the market, causing liquidity to decrease significantly.
The lack of liquidity distorts price discovery and causes massive shifts in asset prices. Such price shifts can lead to increased panic, which further increases uncertainty, and the cycle continues.
In the next section, we will look at two examples of the bandwagon effect in the real world.
SNAP Inc.’s Initial Public Offering
SNAP Inc., a technology company, held its Initial Public Offering (IPO) in early 2017. The IPO came in the aftermath of the great technology rally, which saw a massive appreciation in the stock prices of technology companies, such as Amazon, NVIDIA, Netflix, etc.
The shares of SNAP Inc. were offered at a price of $17 per share. The price appreciated as much as 44% to $24 in a single day. It rose further to $27 two days after the IPO, which was about a 58% appreciation to the initial offer price of $17.
The price surge was followed by a correction to around $20 per share over the next few trading days. The above sequence of events is an example of the bandwagon effect. Investors kept bidding up the price for two days, as they blindly followed other investors into what they all perceived to be another technology company with significant upward potential. Below are illustrations of SNAP IPO’s bandwagon effect and follow-up
October 19, 1987, often called Black Monday, saw the largest market crash in history when the Dow Jones Industrial Index fell 22% in a single day. The crash was attributed to many causes, ranging from economic news to portfolio insurance strategies.
However, a study done by the economist Robert Shiller in the aftermath of the crash points to the bandwagon effect. In the survey conducted by Shiller, most participants pointed to the expectation of an impending crash rather than a concrete reason. The widespread use of portfolio insurance strategies that have been blamed for the magnitude of the crash is further evidence of the bandwagon effect.