{"id":8695,"date":"2020-08-25T00:01:19","date_gmt":"2020-08-25T04:01:19","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=8695"},"modified":"2020-09-21T06:40:02","modified_gmt":"2020-09-21T10:40:02","slug":"behavioral-finance-bias-deep-dive-herding","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2020\/08\/25\/behavioral-finance-bias-deep-dive-herding\/","title":{"rendered":"Behavioral Finance \u2013 Bias Deep Dive: Herding"},"content":{"rendered":"<p><span style=\"font-family: futural;\">Why do markets form bubbles? Why do markets capitulate and collapse in value rapidly? Asked succinctly: why do investors engage in <em>herding<\/em> behavior? This is the fourth in a series of deep dive articles on behavioral finance and its major biases. Ultimately, I am going to land with A Theory of Behavioral Finance. In the meantime, let\u2019s turn our attention to why investors stampede.<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-family: futural;\"><strong>A Helpful Mnemonic Device: LOCHAARM<\/strong><\/span><\/p>\n<p><span style=\"font-family: futural;\">To my mind the major behavioral biases are:<\/span><\/p>\n<ul>\n<li><a href=\"https:\/\/jasonapollovoss.com\/web2020\/08\/04\/behavioral-finance-bias-deep-dive-loss-aversion\/\"><span style=\"font-family: futural;\"><span style=\"text-decoration: underline;\"><strong>L<\/strong>oss aversion<\/span><\/span><\/a><\/li>\n<li><a href=\"https:\/\/jasonapollovoss.com\/web2020\/08\/11\/behavioral-finance-bias-deep-dive-overconfidence\/\"><span style=\"font-family: futural;\"><span style=\"text-decoration: underline;\"><strong>O<\/strong>verconfidence<\/span><\/span><\/a><\/li>\n<li><a href=\"https:\/\/jasonapollovoss.com\/web2020\/08\/18\/behavioral-finance-bias-deep-dive-confirmation\/\"><span style=\"font-family: futural;\"><span style=\"text-decoration: underline;\"><strong>C<\/strong>onfirmation<\/span><\/span><\/a><\/li>\n<li><a href=\"https:\/\/jasonapollovoss.com\/web2020\/08\/25\/behavioral-finance-bias-deep-dive-herding\/\"><span style=\"font-family: futural;\"><span style=\"text-decoration: underline;\"><strong>H<\/strong>erding<\/span><\/span><\/a><\/li>\n<li><a href=\"https:\/\/jasonapollovoss.com\/web2020\/09\/01\/behavioral-finance-bias-deep-dive-anchoring\/\"><span style=\"font-family: futural;\"><span style=\"text-decoration: underline;\"><strong>A<\/strong>nchoring<\/span><\/span><\/a><\/li>\n<li><a href=\"https:\/\/jasonapollovoss.com\/web2020\/09\/08\/behavioral-finance-bias-deep-dive-availability\/\"><span style=\"font-family: futural;\"><span style=\"text-decoration: underline;\"><strong>A<\/strong>vailability<\/span><\/span><\/a><\/li>\n<li><a href=\"https:\/\/jasonapollovoss.com\/web2020\/09\/15\/behavioral-finance-bias-deep-dive-representativeness\/\"><span style=\"font-family: futural;\"><span style=\"text-decoration: underline;\"><strong>R<\/strong>epresentativeness<\/span><\/span><\/a><\/li>\n<li><a href=\"https:\/\/jasonapollovoss.com\/web2020\/09\/22behavioral-finance-bias-deep-dive-mental-accounting\/\"><span style=\"font-family: futural;\"><span style=\"text-decoration: underline;\"><strong>M<\/strong>ental accounting<\/span><\/span><\/a><\/li>\n<\/ul>\n<p><span style=\"font-family: futural;\">A helpful mnemonic device for remembering these biases is LOC HAARM, brain <strong>loc<\/strong>k that <strong>harm<\/strong>s investment performance. Hark! What is that sound? The sound of thousands of hooves herding.<\/span><\/p>\n<p><span style=\"font-family: futural;\"><strong>\u00a0<\/strong><\/span><\/p>\n<p><span style=\"font-family: futural;\"><strong>Herding Bias: Origins and Manifestations<\/strong><\/span><\/p>\n<p><span style=\"font-family: futural;\">Surely if you are reading this article you have heard (pun intended) that market prices sometimes form speculative bubbles and have colossal crashes, yes? Investors generally attribute these two phenomena to a seemingly innate behavior in animals of all kinds, even people, to all move in the same direction at the same time unconsciously\/without regard to reason. This behavior of course is herding.<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-family: futural;\"><u>Market Bubbles<\/u><\/span><\/p>\n<p><span style=\"font-family: futural;\">Most famous in investing to describe herding is journalist Charles MacKay in his 1841 classic, <em>Extraordinary Popular Delusions and The Madness Of Crowds<\/em>.<a href=\"#_ftn1\" name=\"_ftnref1\"><sup><span style=\"font-size: 8px;\">[1]<\/span><\/sup><\/a> Interestingly, the book is not primarily focused on economic bubbles, having just three chapters on the subject. MacKay spends most of time debunking things such as religious fanaticism, fortune-telling, and fashion fads among other things. A single quote from this, his best known work, should serve our purposes here:<\/span><\/p>\n<p style=\"padding-left: 40px;\"><span style=\"font-family: futural;\">\u201cMen, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.\u201d<a href=\"#_ftn2\" name=\"_ftnref2\"><sup><span style=\"font-size: 8px;\">[2]<\/span><\/sup><\/a><\/span><\/p>\n<p><span style=\"font-family: futural;\">Of the economic bubbles, MacKay recounts a series of historical\/hysterical moments in history where investors went crazy for different types of assets. Notoriously, the South Sea Bubble of the 1710s, the Dutch Tulip Bulb Craze of the 1630s, and the Railway mania of the 1840s.<\/span><\/p>\n<p><span style=\"font-family: futural;\">Ironically, MacKay himself is criticized as an ardent booster of bubbles in his role as a journalist.<a href=\"#_ftn3\" name=\"_ftnref3\"><sup><span style=\"font-size: 8px;\">[3]<\/span><\/sup><\/a> For example, researchers have found that when writing during the time of the Railway Mania he said, \u201cThere is no reason whatever to fear a crash.\u201d<a href=\"#_ftn4\" name=\"_ftnref4\"><span style=\"font-size: 8px;\">[4]<\/span><\/a> Other researchers who have done a deep dive into the Tulip Bulb craze have found that its severity was greatly exaggerated by MacKay. In other words, all of us are susceptible to behavioral bias, even if we are considered classic authorities on the subject.<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-family: futural;\"><u>Market Crashes<\/u><\/span><\/p>\n<p><span style=\"font-family: futural;\">It is at this moment though that I need to point your attention to the obvious. Herding is also witnessed when securities prices fall. Though, perhaps they are better called stampedes when there is a rush for the exits.<\/span><\/p>\n<p><span style=\"font-family: futural;\">In my recent article \u201c<a href=\"https:\/\/jasonapollovoss.com\/web2020\/07\/07\/fact-file-sp-500-sigma-events-slight-return\/\">Fact File: S&amp;P 500 Sigma Events, slight return<\/a>\u201d I provide a history of the major market moves up and down of this index. In short, while there is a positive skew to daily stock market returns, the sigma events are remarkably symmetrical. The range of possibilities extends out to 10 sigma events, up and down. Ouch!<\/span><\/p>\n<p><span style=\"font-family: futural;\">In investing there are other manifestations of herding behavior that are much more subtle. At the macro level think about the herding effect created by a combination of blind monthly retirement fund contributions and dollar cost averaging, coupled with index fund\/ETF as a sponge to absorb all of these monies in defiance of the prices and risks of the component businesses. In other words, this is <em>herding by design<\/em>. Could it be that a lot of the success of index fund investing is <em>herding by design<\/em>? Create a list of securities that everyone should buy and then set it up so that they buy regardless of what the performance of that list says.<\/span><\/p>\n<p><span style=\"font-family: futural;\">At the micro level, investment teams can easily lose sight of reality in raging bull markets, and lumbering bear markets, too. Here group think sets in and the same conversations among team members happen over and over again. This is why a hallmark of great investment teams is a constant navigation to truth and not to habit.<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-family: futural;\"><strong>Herding Bias: Nuances<\/strong><\/span><\/p>\n<p><span style=\"font-family: futural;\">Researchers ranging from biologists to mathematicians to economists have all studied herd behavior. For example, in biology it has been noticed that when stampeding each member of a herd reduces its own dangers by orienting itself as closely as possible to the center of the whole herd.<span style=\"font-size: 8px;\"><a href=\"#_ftn5\" name=\"_ftnref5\"><sup>[5]<\/sup><\/a><\/span> Birds flying in a flock are also known to exhibit this behavior. Namely, there is no one leader; and, essentially, each member of the flock is following the others.<\/span><\/p>\n<p><span style=\"font-family: futural;\">I believe this is an apt description of behavior in the midst of asset bubbles, where absolute notions of value and return are surrendered to relative notions of value. That is, absolute valuation based on valuation theory and as derived by discounted cash flow analysis are surrendered in favor of relative valuation. In fact, I think developing a measure of when relative value takes over from absolute value probably provides an insight as to when a bubble has formed.<\/span><\/p>\n<p><span style=\"font-family: futural;\">During bubbles participants crowd into individual securities, or into markets to orient themselves, \u201cas closely as possible to the center of the whole herd.\u201d Most do not want to be left behind or stampeded over. Here the center of the whole herd is the upward march of the aggregate measures of performance, such as indices.<\/span><\/p>\n<p><span style=\"font-family: futural;\">Mathematicians have tried to model this behavior for many different applications, but obviously an understanding of such phenomenon is useful to investors. In a well cited paper, researchers note two important features of herding behavior:<a href=\"#_ftn6\" name=\"_ftnref6\"><sup><span style=\"font-size: 8px;\">[6]<\/span><\/sup><\/a><\/span><\/p>\n<p>&nbsp;<\/p>\n<ul>\n<li><span style=\"font-family: futural;\"><u>Mechanisms of Transmission<\/u>. How thoughts and behavior among people are communicated to one another. Given the near omnipresence of interconnected communications via smart devices and social media this has important implications for investors trying to understand herding.<\/span><\/li>\n<li><span style=\"font-family: futural;\"><u>Patterns of Connections<\/u>. This refers to the way in which different members of the group interact with one another, and from which emergent behaviors come.<\/span><\/li>\n<\/ul>\n<p>&nbsp;<\/p>\n<p><span style=\"font-family: futural;\">Interestingly, this research was written just after the stock market collapse of March 2009. Many investment researchers believe that one mechanism of transmission that is extremely important to herding behavior is asymmetric information.<a href=\"#_ftn7\" name=\"_ftnref7\"><sup><span style=\"font-size: 8px;\">[7]<\/span><\/sup><\/a> Because not all market participants have the same information, when new information emerges there is a tendency of people to overreact to news. This is similar to a scarcity mentality or a gold rush mentality. Limited available gold\/information leads to people crowding into similar decisions to avoid being left out of the scramble.<\/span><\/p>\n<p><span style=\"font-family: futural;\">Referring back to my article about the history of S&amp;P 500 sigma events, I would also like to point out that the 9 and 10 sigma events have all occurred in the era of rapid dissemination of information. All of these events have happened in the era of the Internet, e-mail, and instant messaging except for the October 1987 crash. But even then investment pros had access to instantaneous market movements via the Quotron machine.<\/span><\/p>\n<p><span style=\"font-family: futural;\">A backburner project of mine is to research the \u201cPatterns of Connections\u201d within financial markets. That is to map the network and to check out the most important nodes. My educated guess is that when there are crashes that the opinion of the network nodes switches from favorable to unfavorable opinions about the direction of financial markets.<\/span><\/p>\n<p><span style=\"font-family: futural;\">My last point on this subject is that most investors believe that when they hear news about the \u201cStock Market\u201d such as, \u201cToday investors were concerned that the amount of chicken clucks declined\u201d that \u201cThe Market\u201d means every investor. In reality a very low percentage of the market trades each day. <a href=\"https:\/\/jasonapollovoss.com\/web2012\/09\/10\/fact-file-calculating-the-illusive-size-of-mr-market\/\">Proprietary research I did in 2011<\/a> showed that just 0.35% of the market trades, on average. However, in stampeding years it is 0.64%. What this means is that it takes very few marginal idiots to collapse the value of your portfolio.<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-family: futural;\"><strong>Conclusion<\/strong><\/span><\/p>\n<p><span style=\"font-family: futural;\">To me, herding behavior is clearly a rich source of alpha because it leads to distortions in understanding. Sometimes herding leads to volatility, and sometimes to stability. But those distorted perceptions of reality are opportunities for the clear headed active manager to earn alpha.<\/span><\/p>\n<p>&nbsp;<\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-family: futural;\"><a href=\"#_ftnref1\" name=\"_ftn1\">[1]<\/a> MacKay, Charles. <em>Extraordinary Popular Delusions and the Madness of Crowds<\/em>. Public Domain. 1841<\/span><\/p>\n<p><span style=\"font-family: futural;\"><a href=\"#_ftnref2\" name=\"_ftn2\">[2]<\/a> Ibid. p. 4<\/span><\/p>\n<p><span style=\"font-family: futural;\"><a href=\"#_ftnref3\" name=\"_ftn3\">[3]<\/a> Odlyzko, Andrew. \u201cCharles MacKay\u2019s own extraordinary popular delusions and the Railway Mania.\u201d <em>School of Mathematics, University of Minnesota<\/em>. 26 February 2012<\/span><\/p>\n<p><span style=\"font-family: futural;\"><a href=\"#_ftnref4\" name=\"_ftn4\">[4]<\/a> Ibid.<\/span><\/p>\n<p><span style=\"font-family: futural;\"><a href=\"#_ftnref5\" name=\"_ftn5\">[5]<\/a> Hamilton, W.D. \u201cGeometry for the Selfish Herd.\u201d <em>Journal of Theoretical Biology<\/em>. Vol. 31 (1971): pp. 295-311<\/span><\/p>\n<p><span style=\"font-family: futural;\"><a href=\"#_ftnref6\" name=\"_ftn6\">[6]<\/a> Raafat, Ramsey M., Nick Chater, and Chris Frith. \u201cHerding in humans.\u201d <em>Trends in Cognitive Sciences<\/em>. Vol. 13, No. 10 (2009): pp. 420-428<\/span><\/p>\n<p><span style=\"font-family: futural;\"><a href=\"#_ftnref7\" name=\"_ftn7\">[7]<\/a> Brunnermeier, Markus K. <em>Asset Pricing under Asymmetric Information \u2013 Bubbles, Crashes, Technical Analysis and Herding<\/em>. Princeton University Press. 2000<\/span><\/p>\n<p>&nbsp;<\/p>\n<p>&nbsp;<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Why do markets form bubbles? Why do markets capitulate and collapse in value rapidly? Asked succinctly: why do investors engage in herding behavior? This is the fourth in a series of deep dive articles on behavioral finance and its major biases. Ultimately, I am going to land with A Theory of Behavioral Finance. In the [&hellip;]<\/p>\n","protected":false},"author":2,"featured_media":8698,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_et_pb_use_builder":"","_et_pb_old_content":"","_et_gb_content_width":"","footnotes":""},"categories":[407,3],"tags":[244,289,23,22,398,399,397],"class_list":["post-8695","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-behavioral-bias-deep-dive","category-the-blog","tag-behavioral-bias","tag-behavioral-biases","tag-behavioral-economics","tag-behavioral-finance","tag-charles-mackay","tag-extraordinary-popular-delusions-and-the-madness-of-crowds","tag-herding"],"_links":{"self":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts\/8695","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/comments?post=8695"}],"version-history":[{"count":0,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts\/8695\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/media\/8698"}],"wp:attachment":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/media?parent=8695"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/categories?post=8695"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/tags?post=8695"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}