Herding

Noah Smith prompted a lot of discussion in the blogosphere with his posting, “Does trend-chasing explain financial markets?”  It was complete with a photo of bison charging at the viewer, visually emphasizing the instinctual reaction to join the crowd rather than to stand against it.

Smith linked to a variety of academic studies about the nature of the stock market, focusing his narrative on two competing philosophies of investor behavior:  “extrapolative expectations” (chasing the trends) and “rational expectations,” the bedrock of most academic finance work.  (Presumably, the debate would be similar with other asset classes, but it always seems to be about stocks.)

Among the questions prompted by the piece:  Is “trend-chasing by quasi-rational investors . . . the big force behind long-term stock return predictability”?  And — not surprisingly — “Could models be constructed to predict the peaks of bubbles?”

Even if trend-chasers dominate and determine prices most of the time, Smith ponders, “There must be some subset of investors that, at some point, decides that prices are just too egregiously out of line with fundamentals, and acts together to kill the trend.”

There is a great deal to chew on in the article, the papers that are cited, and the extensive comments, which demonstrate the diversity of views and players in the investment ecosystem.  Among those pitching in are chartists, anti-chartists, game theorists, investors, traders, academicians, people for whom the ideas seem novel, and others for whom they seem old hat.

But let’s step away from the debate for just a second and take a sociologist’s perspective, observing what people actually do.  The investing behavior of individuals has been well documented over the years.  “People don’t change,” wrote Josh Brown recently, summing it up.  “Flows don’t follow value, they follow performance.”

And that is not just true of individuals, but of financial advisors, asset managers, consultants, institutional investors, and on and on — not only in regard to the flow of money to the best-performing assets, but in a transfer of allegiance to the concepts and strategies and philosophies that the sun has been shining upon.

This is a business of herding.  There’s no way around it.

And so, all players must decide what game they are playing.  There are many games from which to choose, but let’s focus on the dimension at issue here.  The herding creates opportunities from the forces of momentum and also from their reversal.  Which are you trying to capture, why, and how are you doing it?

In Pioneering Portfolio Management, David Swensen wrote that “investment success requires sticking with positions made uncomfortable by their variance with popular opinion.”  That philosophy requires leaning against the momentum at certain times.

Other investing philosophies focus on capitalizing on that momentum, but I use Swensen’s quote because not very many investment professionals or fiduciaries would describe themselves as trend-followers — and they certainly wouldn’t cop to chasing performance.  But that is, in fact, what most do.

Throughout the business, we have institutionalized herding.  Behaviorally, the penalties for standing out from the crowd are too great for most of us, but there’s more to it than that.  With some exceptions, the assessment and selection processes at every layer of investing activity are strongly biased to trend-following.  Not that there’s anything wrong with that — if that is what you’re trying to do.  But most deny following the herd, even as their methods ensure that it happens.

One exception is the process of rebalancing.  Its benefits can be argued (and they vary over time), but it is a simple, effective, and widely-adopted approach to minimizing the potential distortions caused by extended trends.  However, you rarely find the same mentality carried over into other parts of the investment process, where relative measurements trump absolute ones in making choices.

For those of us involved in analyzing and designing investment decision structures, this is a very big deal.  How we choose to confront this business of herding is absolutely foundational, and it ought to be clearly stated in our investment beliefs and the organizational decisions that support them.