Thought Leaders: Investing
Herd on the Street
Robert Prechter and Wayne D. Parker
01/01/2008

How can a portfolio full of AAA-rated mortgages lose 50 or even 100 percent of its value in a single quarter? Why do stocks of companies that lack decent earnings leap 1,000 percent in a few weeks? Why do investors rush to invest in hedge funds one month and line up for redemptions the next? Are such extreme events really based on information and logic?

Economists have long puzzled over these inconsistencies in investor behavior and market performance. And in volatile times like these, it can be comforting to look for some new answers. We believe we have found one.

Distinguishing between financial and economic choices helps explain the sometimes contradictory behavior of investors. As we reported in the summer 2007 issue of the Journal of Behavioral Finance, our findings show that people behave differently when they are uncertain about how others will value investments in the future (finance) than when they are relatively certain about how they value goods and services personally (economics). In the first instance, they unconsciously herd with others and then rationalize their decisions. But in the second case, they approach value rationally and consciously. These insights come from the still-nascent field of "socionomics"—the study of human social behavior in the context of uncertainty.

The efficient-market hypothesis claims that financial mar-kets act like those for goods and services: Information is processed so efficiently that all relevant facts about any stock or bond are already reflected in its current price. It also assumes that the law of supply and demand regulates financial markets.

The law of supply and demand often gets flipped on its head in financial markets.

But the law of supply and demand often gets flipped on its head in financial markets. As a stock’s price rises, demand for it tends to increase. When prices are low, few want to buy. This is exactly the opposite of what happens in the butcher shop or the shoe store, where higher prices curb demand and lower prices enhance it. It is also contrary to what is supposed to happen in financial markets according to economic theory. When behavior runs contrary to theory, it is time for a new theory—and the socionomic theory of finance better accounts for such behavior. The law of supply and demand regulates prices in the economic realm. But we propose that something else—the law of patterned herding—rules prices in the financial realm.

Mood Drivers
As the great economist John Maynard Keynes once noted, accurately predicting financial markets is like calling the outcome of a beauty contest: You must pick the winner by choosing not the one that you think is most beautiful, but rather the one that you bet others will think is most beautiful. In financial markets, when everyone guesses at the crowd’s choices and follows its lead, the result is herding, whether investors realize it or not. Because a crowd does not reason, its mood instead becomes the main driver behind the fluctuations in stock prices.

Herding adds to extreme price movements on both the upside and the downside. When prices are on the rise, most investors do not make a conscious decision to assume more risk in pricey markets; rather, they experience a feeling of risk reduction by joining the herd. All of this is usually unconscious. And what is going on at the conscious, reasoning level during herding? Investors work overtime rationalizing decisions to join the herd based on earnings reports, Federal Reserve Board actions, political events and similar news. Financial commentators boldly predict market moves on 24-hour cable news shows or in publications, but none of them really know where markets are going. When no explanation seems to fit, they attribute market action to "psychology." In our model, psychology always matters.

The efficient-market hypothesis claims that no one can invest successfully on a regular basis because the market swings randomly. But we have some good news. If investors can overcome the impulse to herd and dispassionately read the mood of the crowd, they will have an edge.

Robert Prechter is the author of Socionomics: The Science of History and Social Prediction. Wayne D. Parker, a psychologist who has been an adjunct faculty member at Emory University School of Medicine in Atlanta, is the executive director of the Socionomics Foundation.