Explaining Herd Behaviour In Investing

3rd May '10 by timarr

3 comments 4294 reads

It seems sort of obvious that investors, a generally bovine group when not in asinine mood, will tend to congregate in herds and then charge about randomly, often over the edge of the nearest cliff. If this is true, however, it poses a set of puzzles that it's not clear that any of the current approaches to understanding mass market behaviour can properly explain. Certainly this behaviour isn't efficient in the sense of obtaining the right price for a security, because deciding what to do based on the person running about in ever-decreasing circles next to you doesn't come close to propagating useful information. However, if investors are irrational in herds then this implies that somehow their behaviour is synchronised and it's certainly not clear that the simple set of isolated psychological biases that analysts currently work with is anywhere near sufficient to explain this.

Flocking and Herding

A simple model of flocking in computer models has been shown to be sufficient to generate surprisingly realistic herding behaviour – the sort of thing we looked at in Boids, Bacteria and Market Behaviour. Being able to show that this type of model can produce something that looks like the synchronised behaviour we see in the real-world is a long way from explaining how it works, however, because humans demonstrate intentionality – that is, we don't normally work on some pre-programmed autopilot but have internal motivations that cause us to do things based on personal preferences. Or do we? One of the other noticeable attributes of humanity is its strong tendency for mimicry. From a very young age human children copy adults and the urge to imitate is found in many higher animals. Indeed it's been suggested that the large human brain evolved in response to selective pressures to copy others. This idea would be more credible if there weren't dozens of alternative evolutionary theories for the size of our crania – this one-size-fits-all theorising is one of the reasons why many people are sceptical of adaptationist claims: natural selection can be adduced to explain everything, so in the end may explain nothing.

Information Cascades

This aside, it certainly seems that mimicry lies behind a lot of observable animal behaviour, from mate selection through to dietary choices. Especially in situations of uncertainty it makes perfect sense to copy what everyone else is doing. You just hope…

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Dlyricist

3rd May '10

Excellent article, so true regarding exposure attracts you to buy it.....so a way around is to create and research a short-list then pick a pre-defined number to watch/buy

emptyend

4th May '10

Some interesting thoughts in there. You last paragraph in particular prompts the following thoughts:

1) TA is merely a shorthand by which people ATTEMPT to assess herd behaviour

2) Despite the fact that virtually all TA adherants seem to deny when challenged that TA is predictive, they still attempt to position themselves (and set stops) as if TA was a useful predictor of where the herd will go to next

3) Making money relies on being ahead of the herd in getting in and out. Since TA is backwards-looking, it isn't very useful in helping investors do this.

rgds

timarr

6th May '10

Oddly enough there is evidence that TA does work, a bit. Certainly there’s no doubt whatsoever that momentum investing is an effective technique, over periods of up to a year. Over periods of over three years looking for mean reversion is the better approach. The problem for momentum investors is deciding when the trend will turn, and I’ve never seen any convincing evidence that TA can reliably do this. In fact if it could then you’d assume that people would try to anticipate the turn to the point where the signal would dissolve in noise.

The question in both cases, which I’m currently pondering, is whether excess returns are really the result of exploiting herding psychological weaknesses or simply the result of taking on additional risk. You probably don’t want to be betting on an up-trend when the market turns turtle, but you probably don’t want to then invest in a bunch of beaten-up cigar butts, aka ‘value’ stocks, either. In fact perhaps the closest thing to a free lunch in markets is buying quality stocks during a downturn and then holding onto them.

Which, if true, means that the problem reduces to deciding what a “quality stock” is …

Explaining Herd Behaviour in Investing

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Timarr

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