From rabid football fans to crazed nationalists, or religious fanatics, sometimes the need to be part of the group can strip us of our reason and force us to make some very irrational decisions. This is especially true of investors

William Gamble

English has a number of expressions for following crowds. "Jump on the bandwagon", "the trend is your friend", "followers of fashion", "herd mentality", "peer pressure". They all describe our proclivity as humans to go with a group. Like other animals we like to travel in packs. We feel afraid when we are alone, and acting in groups or teams can be especially satisfying. From rabid football fans to crazed nationalists, or religious fanatics, sometimes the need to be part of the group can strip us of our reason and force us to make some very irrational decisions. This is especially true of investors, but can it help or hurt?

Financial history is replete with examples of financial excess, where investors, looking for the greater fool, bid up assets beyond anything rational or even sane. The results have always been a disaster. The housing bust and the dot.com crash are notable in the United States, but there are plenty of others. The Saudi stock market reached a high of 20,634 in 2006 and has never fully recovered. It is presently trading at only 30% of its all-time high. Despite predictions of endless growth, the Chinese Shanghai A market is still only half of its 2007 highs. Gold spiked in a bubble in 1980 and then crashed. It did not regain its former highs for 26 years. We are undoubtedly witnessing the same behavior now. So following a crowd can result in behaving like a lemming and jumping off a financial cliff.

One reason we have the tendency to follow crowds is because of what are called cognitive biases. These are defined as a pattern of deviation in judgment that occurs in particular situations. Many are considered evolved or adaptive behaviors, sort of a mental short hand that allows us to make quick decisions when either time or sufficient information is not available.

Two of the most important are the Bandwagon Effect and the Herd Instinct. These of course are the common tendency to adopt the opinions and follow the behaviours of the majority to feel safer and avoid conflict. These are reinforced by other biases like the availability cascade. This occurs when a statement is repeated often enough until people assume it is true, a virulent problem with internet information. For investors this makes them disregard regressions toward the mean and expect extreme performance to continue.
 
These biases lead investors to always chase trends even when there are not any bubbles. According to a recent survey conducted by The Economist, investors poured money into sectors that had over the past year beat the average by more than two percentage points. Then they lost money because "over the next 12 months that most popular sector lagged behind the average by just under three percentage points" as the sectors reverted to mean.
 
US mutual funds that have the Morningstar 5 star ratings are supposed to be indications of stellar performance. After the crash, the herd stampeded from three-star funds which lost $111 billion, to five-star funds that enjoyed $67.5 billion of net inflows. The reality was almost 90% of the US equity funds with a five-star rating lagged their category averages, both for other mutual funds and for their benchmarks.

But can crowds sometimes be right? Certainly there is evidence for the wisdom of crowds. One or two people guessing the number of beans in a jar will be wildly off. When many people guess, they can come quite close, provided their forecasts are truly independent. When people know what the other guess were, they tend to conform.

Still every bubble does have an upside. There is quite a bit of evidence that suggests buying stocks (not sectors) that have had a good run over the past six months, will produce good returns over the next six months. This is called the momentum effect. Academics found that the effect was consistent in 17 of the 18 markets. Japan was the only exception. It also does not work all of the time. Since November, utilising this strategy would have resulted in losing 11% in Europe and 8% in the US. There are now ETFs designed to follow this strategy.

The problem with the momentum effect, like a value strategy, is that although it has an excellent long-term record, over the shorter term, and by shorter I mean years not decades, it may achieve very bad results. The value strategy has not been particularly helpful in the past three years and momentum strategists would have lost half their money in 2009.

So do you follow the herd and feel secure only to find out that the expensive stock you bought is "so last year", or do you go with the trend, but try to jump off before there are no longer greater fools? Only a truly wise investor would know and those are rarely part of any herd.
 
(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])