NISM-Series-X-B: Investment Adviser (Level 2) · Basics of Behavioural Finance
Herding, Bubbles and Crashes in Market Behaviour
Updated 11 October 2026 · Fact-checked
Herding is investors copying the crowd instead of using their own analysis. Together with momentum and sentiment, it can push prices far from fundamental value, creating bubbles. When sentiment reverses, selling feeds on itself and prices crash. To solve questions, identify the bias, the market stage and the adviser's response.
Understand Market Behaviour: Herding, Bubbles and Crashes
Traditional finance assumes investors are rational and prices reflect all available information. Behavioural finance asks what happens when many investors act on emotion and shortcuts at the same time. Their errors do not cancel out. They add up, and prices move away from fundamental value.
Herding means following what others do. Investors buy because everyone is buying, or sell because everyone is selling. It happens for two broad reasons: people assume the crowd knows something they do not, and people fear regret from standing alone and being wrong. Momentum is the tendency of recent winners to keep rising for a time, partly because investors chase past returns. Investor sentiment is the overall mood of investors, optimistic or pessimistic, which can drive prices beyond what facts justify.
A bubble is a sharp rise in prices well above fundamental value, driven by enthusiasm and herding rather than earnings or cash flows. A typical path: a genuine story starts the rise, early gains attract more buyers, overconfidence and fear of missing out build, and people justify high prices with 'this time is different'. A crash is a sudden, steep fall when sentiment turns. Loss aversion and panic make people sell together, and falling prices trigger more selling.
These patterns help explain market anomalies, which are price patterns that the efficient market hypothesis struggles to explain. Examples are momentum, overreaction to news followed by reversal, and excess volatility. Behavioural finance offers explanations. It does not claim anomalies can be reliably traded for profit.
For an investment adviser, the lesson is practical. Do not let a client chase hot themes or sell in panic. Use a written asset allocation, rebalancing and regular review to keep decisions disciplined.
Key formulas to remember
- Herding
- Decision = copy the crowd, not own analysis
- Driven by assuming others are better informed and by fear of regret. It is a group behaviour, not an individual bias like overconfidence.
- Bubble path
- Displacement → boom → euphoria → profit-taking → panic
- A common stage model. Prices exceed fundamental value at the euphoria stage. Know the order and what investors feel at each stage.
- Momentum
- Recent winners tend to keep winning in the short to medium term
- A tendency, not a guarantee. It often reverses sharply when sentiment turns.
- Bubble versus fundamentals
- Bubble = market price ≫ fundamental value
- The gap is explained by sentiment and herding, not by changes in earnings or cash flows.
- Efficient market contrast
- EMH: prices reflect information; behavioural view: sentiment can move prices away from value
- Anomalies are evidence that raises questions about market efficiency.
How to solve Market Behaviour: Herding, Bubbles and Crashes questions
Use this method for any scenario or concept question on market behaviour.
- 1Read the scenario and note what investors are doing: copying others, chasing past returns, or selling in fear.
- 2Identify the behaviour: herding, momentum, overconfidence, loss aversion or sentiment.
- 3Place the market on the bubble path: early boom, euphoria, or panic and crash.
- 4Check whether price is moving with or against fundamentals such as earnings.
- 5Link the behaviour to the anomaly or outcome the question asks about.
- 6Match the adviser's response: stick to the plan, diversify, rebalance, avoid chasing trends.
- 7Eliminate options that claim anomalies guarantee profit or that investors are always rational.
Quickest way: Keyword-to-concept mapping
When to use it: Use when time is short and options look similar.
- 'Everyone is buying' or 'following the crowd' points to herding.
- 'Past winners keep rising' points to momentum.
- 'Prices far above earnings, euphoria' points to a bubble.
- 'Mass selling, panic, sharp fall' points to a crash.
- 'Mood of investors' points to sentiment.
- Pick the option that keeps the client disciplined and rule-based.
Common mistakes in Market Behaviour: Herding, Bubbles and Crashes
Treating herding as an individual bias like overconfidence.
Both involve emotion, so they blur together.
Fix: Remember herding is about copying others. Overconfidence is about overrating your own skill.
Saying bubbles are caused by rising earnings.
Students link rising prices with strong fundamentals.
Fix: A bubble is a price rise beyond fundamental value, fuelled by sentiment.
Believing momentum always continues.
The word suggests unstoppable movement.
Fix: Momentum is a tendency and can reverse suddenly when sentiment changes.
Claiming behavioural finance gives a sure way to profit from anomalies.
Students overstate what anomalies prove.
Fix: Anomalies challenge market efficiency. They do not guarantee profits, especially after costs and risk.
Advising a client to follow the crowd to avoid regret.
It feels safe and social.
Fix: The correct adviser action is a plan-based approach with diversification and rebalancing.
Worked examples
Example 1
Prices of small-cap stocks in a sector rise sharply for months. Retail investors buy mainly because friends and social media posts say others are making money. Valuations are far above earnings. Which behaviour and market stage best describes this? (A) Anchoring, early recovery (B) Herding, euphoria stage of a bubble (C) Mental accounting, panic (D) Loss aversion, crash
Show the solution
- Investors buy because others are buying. This is herding.
- Valuations far above earnings means price exceeds fundamental value.
- Strong optimism and rising prices match the euphoria stage, not panic or crash.
- Options A, C and D name the wrong behaviour or the wrong stage.
Answer: (B) Herding, euphoria stage of a bubble.
Example 2
A client wants to sell all equity funds after a sharp market fall because 'everyone is selling'. As an adviser, what is the most appropriate response?
Show the solution
- Identify the behaviour: herding combined with panic and loss aversion during a crash.
- Recall the aim: protect the client from decisions driven by emotion.
- Revisit the client's goals, time horizon and agreed asset allocation.
- Explain that the fall may reflect sentiment, and that selling at lows locks in losses.
- Suggest staying with the plan, rebalancing if allocation has drifted, and reviewing only if goals or risk capacity have changed.
Answer: Do not follow the crowd. Return to the documented plan and asset allocation, rebalance if needed, and change course only for changes in the client's goals or circumstances.
Exam tips
- Expect scenario questions where you must name the behaviour. Look for the key phrase, such as 'everyone is buying'.
- Learn the bubble stages in order and the dominant emotion in each.
- Wrong options often say anomalies guarantee profit or that markets are always rational. Reject them.
- Adviser-response questions reward the rule-based, plan-led answer.
- NISM X-B has negative marking of 25% of the marks for a question, so skip only if you cannot narrow to two options.
Practice questions from Basics of Behavioural Finance
- In prospect theory, which feature of the value function best explains why investors often sell winning investments too early while holding l…
- Which of the following is classified as an emotional bias, as opposed to a cognitive bias, in behavioural finance?
- A client sells a stock immediately after it rises 8% to lock in the gain, but holds another stock that has fallen 25% hoping it will 'come b…
- Mr. Rajesh Iyer, 45, invested in a small-cap fund after it returned 45% in each of the last two years. He says, 'This fund manager clearly c…
- Under prospect theory as proposed by Kahneman and Tversky, which statement is correct about how people evaluate outcomes?
Market Behaviour: Herding, Bubbles and Crashes in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Market Behaviour: Herding, Bubbles and Crashes: frequently asked questions
What is herding behaviour in stock markets?
Herding is when investors follow the crowd instead of doing their own analysis. It comes from assuming others know more and from fear of regret. It can push prices well away from fundamental value.
How does behavioural finance explain market bubbles?
Bubbles arise when optimism, herding, momentum chasing and overconfidence drive prices above fundamental value. Early gains attract more buyers, which lifts prices further. The bubble ends when sentiment reverses.
What causes a market crash in behavioural terms?
A crash happens when sentiment turns and investors sell together out of fear and loss aversion. Falling prices trigger more selling. The fall can overshoot fundamental value.
Are market anomalies proof that you can beat the market?
No. Anomalies such as momentum raise doubts about market efficiency. They do not guarantee profits, since costs, risk and reversals can remove the gains.