The herd mostly gets it wrong
In this post we will look at a set of Kahneman style risk policies designed to help us avoid succumbing to herding, peer pressure and groupthink.
We can all conjure up in our minds an image of a huge flock of birds overhead changing direction in unison. Or we can imagine a mass of animals on the Serengeti Plain in Africa racing along only to swerve as a herd in a new direction. This is herding behavior.
Humans do it
I would hazard to say that all stock market prices are both the cause and the result of herding behavior. I’m not talking about just day to day market action. It can also happen over weeks, months and years. And, it’s not just in market bubbles and busts. It happens all the time.
Shiller points out that: “the popular notion that the level of market prices is the outcome of a sort of vote by all investors about the true value of the market is just plain wrong. Hardly anyone is really voting. Instead people are rationally choosing not to, as they see it, waste their time and effort in exercising their judgment about the market, and thus choosing not to exert any independent impact on the market.” (Shiller, Irrational Exuberence 2005 Second Edition) p.160.
Fox tells us about Irvine Fisher, a leading American economist in his day who graduated from Yale in 1888. In his 1906 book, The Nature of Capital and Income, Fisher wrote: “Were it true that each individual speculator made up his mind independently of every other as to the future course of events, the errors of some would probably be offset by those of others. But, as a matter of fact, the mistakes of the common herd are usually in the same direction. Like sheep, they all follow a single leader.” (Fox, The Myth of the Rational Market, A History of Risk, Reward, and Delusion on Wall Street. 2009)p.13.
So, where does herding come from and how strong is the urge? We know we have the capacity for independent thought. But, it seems Humans are all too affected by the views of others. The issue comes up in many contexts. At the most extreme is the madness of crowds and mobs. Such madness is a real pathological human trait. Herd and lemming-like behavior are also fairly extreme.
More subtle are peer and career pressures. More subtle again and still very powerful is group thinking (Groupthink).
And then there are the forces that cause us to do what others are doing because we believe that what everyone else is doing must be right. This has been called ‘social proofing’.
The investing crowd is not assembled in a gigantic meeting hall. There is no committee meeting and verbal sharing of views. Nevertheless, a kind of Groupthink occurs.
Professional analysts are humans
Analysts’ reports and investment advisors’ guidance are also the product and cause of herding behavior.
Let me refer to some evidence on this. Gerd Gigerenzer is currently the director of the Max Planck Institute for Human Development in Berlin in Germany.
Gigerenzer assembled data showing ten years’ worth of predictions of following-year exchange rates made by twenty-two of the world’s largest banks. His conclusion was that they were essentially worthless. Like a flock of birds, the twenty-two forecasts clustered together and headed together (herding) and the actual exchange rate the following year was almost always outside the cluster of forecasts (the herd got it wrong). (Gigerenzer, Gerd, Risk Savvy, How to Make Good Decisions 2014) p.86
Money managers and investment advisors
Even investment advisors who are paid an annual fee regardless of trading activity are susceptible to herd like behavior, peer pressure and client pressures. As experts, investment advisors are likely to be the source of overly conventional advice.
As John Maynard Keynes put it succinctly in The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes, The General Theory 1936, 2007) p.158.
Keynes was money manager for a college at Cambridge. He chafed with the investment committees he dealt with. In The General Theory he wrote: “…it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion.” (Keynes, The General Theory 1936, 2007) p.158.
Let me give you my gap-to-edge rules to counter herding behavior. They are my version of what Daniel Kahneman (Nobel Prize in economics) calls risk policies. Kahneman describes risk policies as decision rules that are always applied in similar situations.
This post is part of a multi part series titled ‘A set of rules to develop a behavioral edge’.
So far there have been three posts and three sets of gap-to-edge rules:
Part 1 the problem of short term thinking.
Part 2 the attractive trap of extrapolating the most recent past into the future
Part 3 control our animal spirits when faced with risky situations.
Gap-to-edge rules for this post
The following rules are designed to counter our all too human urge to do what everyone else is doing.
Gap-to-edge rule: When all is going well in the stock market, be wary. When all is going badly, take heart from the opportunities that present themselves.
Be reminded of four of John Templeton’s Maxims.
Maxim 3. It is impossible to produce a superior performance unless you do something different from the majority.
Maxim 4. The time of maximum pessimism is the best time to buy. And vice versa. Buy when published predictions reflect an unusual level of gloom and sell when the consensus is unusually optimistic. This applies to share prices generally and also for particular industries.
Maxim 5. To put “Maxim 4” in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.
Maxim 6. To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
Gap-to-edge rule: Do not to be contrary just to be contrary. We must be prepared to be contrary when our independent judgment tells us to be. Sometimes the crowd is right.
Gap-to-edge rule: Maintain some physical and mental distance from Wall Street.
It may be no coincidence that two the most successful investors of the last one hundred years lived and worked a long way from Wall Street. Both Warren Buffett, who has lived and worked in Omaha, Nebraska, and John Templeton, who lived and worked in Lyford Cay in the Bahamas, kept their distance.
John Templeton’s walks along the beach or sitting and watching the sea may have been one of his personal gap-to-edge rules. Today it might be called a habit of deliberate mindfulness. In a connected world, getting away from the phones allows you to disconnect. This is surely not a bad thing with all the pressures and problems of herding.
Gap-to-edge rule: Take nothing on faith from experts.
Analysts and other experts have many fine ideas and opinions. They also have many bad ideas, suffer from biases and make errors. Every recommendation should be supported by simple empirical evidence that a person of average intelligence can understand.
Gap-to-edge rule: Develop and hold a strong sense of intrinsic value. Reframing from price to value is one of the most important ‘risk policies’ in the successful investor’s tool kit.
Gap-to-edge rule: Remember that when things seem too good to be true, they usually are.
Gap-to-edge rule: Don’t be afraid to be out of step with everyone else
Readers wishing to read deeper into this subject can check out the Motherlode Chapter 19. Our Urge to Do what Everyone Else is Doing
And particularly Sections:
19.01 Crowd mentality is nothing new
19.02 The others can’t be wrong!
19.05 Answering an easier question
19.07 Psychological anchors for the market as a whole
19.08 Experts and authorities are susceptible to Groupthink
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
You can reach me by email at firstname.lastname@example.org
I’m also on Twitter @rodneylksmith
Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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