What’s An Anti-Shepherd To Do? : The Defence Against Herding

What are the factors that drive the lemming-like behaviour among investors? Access to the same set of information, interactions with each other, or a prominent, influential voice that sways many to his side, are just some of the examples that spur herding behaviour.

From “Herding and Contrarian Behavior in Financial Markets – An Internet Experiment” (June 2004) by Mathias Drehmann, Jörg Oechssler and Andreas Roider,

Several sources of rational herding are known to the theoretical literature. For example, when market participants’ payoffs depend directly on the behavior of others, herd behavior is natural. Such payoff externalities cause herding of analysts or fund managers in models of reputational herding (e.g., Scharfstein and Stein, 1990), or herd behavior of depositors in bank runs (e.g., Diamond and Dybvig, 1983).

Even if such payoff externalities are absent, however, herd behavior may be observed in markets through a process of information transmission. Models based purely on informational externalities were pioneered by Bikhchandani, Hirshleifer and Welch (1992), Welch (1992), and Banerjee (1992). An informational cascade is said to occur when it becomes rational to ignore one’s own private information and instead follow the predecessors’ decisions. Since no further information is revealed once an informational cascade has started, inefficiencies occur even though each individual is behaving rationally.

This herding behaviour is not only limited to investors. Analysts are also susceptible, according to the FT,

But the way some people see it, the slow death of the sell recommendation is also a symptom of a deeper, structural change. Equity research teams are clinging to “buys” and “holds” because they do not want to upset colleagues in other parts of the bank. Commissions from trading stocks are falling, thanks to thin volumes and greater competition from electronic brokers. At the same time, with profits squeezed by low interest rates and regulatory penalties, banks are trying to maximise revenues by selling as many services as possible to their most active clients. So why risk offending a chief executive by slapping a sell rating with the bank’s name on it?

As many funds rely on analyst recommendations, usually one of their strong signals, this uniformity of ‘opinions’ exacerbate the situation.

In addition, reputational herding arises from ‘concerns of fund managers vis-a-vis outside observers (e.g., potential future employers)’. From the paper, “Reputational Herding in Financial Markets: A Laboratory Experiment” (Jan 2015) by Andreas Roider and Andrea Voskort, it was found that,

a substantial fraction of investors seems to follow an established trend even in the absence of reputational incentives, and reputational concerns do not seem to affect behaviour much.

I couldn’t agree more with the authors when they urged that, “understanding the exact reasons for herd behaviour is important in order to potentially come up with ways of how to reduce this source of mispricing in financial markets”. However, it would be a good idea to bear in mind that this study might not be the last word on reputational herding.

The solution though, does not lie in rectifying the ‘irrational exuberance’ as described by Robert Shiller,

Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.

Why? Because it is not the rationality of the persons that is at fault, but rather the vicious cycle of stale information that locks the agents into a perpetual, implicit agreement to keep buying. In other words, it is not in the interest of any of the agents to discontinue the fairy tale despite their understanding of the reality on the ground.

To add oil to the fire, major funds are backtesting their strategies, which will usually introduce positive bias towards trend following. This is because it is a strategy that time and again, produces the most dependable short term gains.

Mutual funds often amplify these trends. Individual investors will select funds based on recent performance, which will then force mutual fund managers to invest these flows into the same stocks that drove strong performance. At the same time the incentive to present a portfolio of recent winners is a powerful mechanism to perpetuate these trends.


Could contrarian investing then, remedy the situation? I am not so convinced. Contrarian investing implies the possession of private information, but advantageous and profitable private information is difficult to come by. Even if there is a small subset of investors that are skilled at contrarian style investing, this subset is presumably not significant enough in majority to prevent herding or informational cascades from happening.

Value investing or other non-momentum ways of investing may help. But again, the constant revision of what is actually ‘cheap’ gives doubt to my mind that their existence would stem the herding behaviour. In fact, there has been quite a debate lately as to whether the market is overpriced or not, wringing out discussions of Shiller PE and other market valuation methods. You would think that these discussions of market valuation would also help to stem herding, but there too, I have my doubts. So what then, is the antidote to herding behaviour?

There are truly very limited cures once informational cascades have begun as the actions of the market agents are driven by information, both public and private, as well as individual incentives. Perhaps it is not so blasphemous after all to suggest that market prices might be in need of an externally induced chaos, but in a controlled manner. An agitation if you will, a strong enough incentive that a critical number would break ranks and reach individually unique valuations of the market. That however, is easier said than done.


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