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Why herds exist

PSI |  25 October 2013  |  Portfolio

HerdsAnyone who has spent some time investing will have noticed the herd instinct in markets. They will probably also have noticed that they have joined the herd from time to time, selling out when things are bad and buying when things are high. It is a characteristic of human beings in crowds that never changes.

It is a perrenial problem with stock analysis or economic analysis, which at least purport to be based on logic. But markets are not logical, they rarely do what is predicted. This is in part because those who know the logic try to exploit it -- thus defeating the logic.

The latest Nobel prizes in economics went some way to acknowledging the issue. One of the winners was Eugene Fama, who describes how the rapid absorption of information changes predictions. It is why paying high prices to fund managers to manage your super often is not justified, no matter how clever the "professional" fund managers are. The Economist comments:

"Mr Fama’s great insight was that, because profit-seeking investors quickly incorporate new information into asset prices, the movements of those prices are not predictable in the short term, and thus professional fund managers are unlikely to beat the market. This revolutionary notion led to the development of the index-tracking industry, which allows small investors to diversify their portfolios at very low cost. Pundits who seek to persuade the public to follow their stockmarket tips may curse Mr Fama’s work, but the underlying principle—there are no free lunches to be had—still holds good. Mr Fama’s faith in the efficiency of markets has some limits, however, since he set up a fund-management firm that exploits market anomalies, such as the way that companies which are priced cheaply relative to their assets tend to outperform."

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Yep, in the short term your guess is often as good as a professional's. Another winner was Robert Shiller, co-founder of the Case-Shiller index of house prices that was a harbinger of the GFC:

"The reason markets are volatile, according to Mr Shiller, is that financial assets are unlike consumer goods; when their prices rise, that creates more demand, not less. Nothing is more intoxicating to an investor than seeing a friend get rich; everyone wants to jump on the bandwagon. It is no use hoping that “rational” investors will drive prices back to fair value. Such sobersides get knocked over by the stampede, losing their shirts or their clients.

"Hence the recent bubbles in asset markets. Mr Shiller’s data show that house prices rose by 7% in real terms between 1890 and 1997 and then by 85% between 1997 and 2006. As for American shares, equities traded at 44 times cyclically adjusted profits (using a ten-year average) at the height of the dotcom boom, compared with a long term average of 16.

"Central bankers, led by Alan Greenspan, the Federal Reserve’s chairman from 1987 to 2006, argued that it was impossible to spot bubbles when they are happening. They also said that using higher interest rates to prevent bubbles from forming would do the economy more harm than good. But the central banks did intervene to prop prices up when markets wobbled in 1987 and again in 1998, even when the economy was fairly robust. This “asymmetric ignorance”, as it was dubbed, may have led to greater risk-taking and more bubbles, because traders felt they were underwritten by the “Greenspan put”."

It is hard, in other words, to be rational in the long term. As Keynes famously said, markets can remain irrational longer than you can remain insolvent. That applies to professional fund managers, too. Many have concentrated on the irrational part of Keynes' quote. But the more important lesson is: 'remain solvent no matter what happens.'

 

 

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