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