Market Ethos: Herd Behavior

Market Ethos: Herd Behavior

by Craig Basinger, CFA, Connected Wealth, RichardsonGMP

The human species learned long, long ago that sticking together is a good thing. During our evolution, larger numbers provided safety from predatory animals and other groups of humans. While this may sound abstract today given the lack of dangerous animals looking to make a meal of us, herd behavior is alive and well based on numerous psychological studies. This conforming tendency to align with the opinions and views of a larger group makes us feel safer and helps avoid conflict. Subjects in an experiment would actually later admit to making a selection they knew was wrong but did so after watching other subjects (who were actually planted experimenters) make the wrong choice ahead of them.

Herd behavior also results in groupthink. In corporate meetings, a view that is tabled early in meetings often carries throughout the meeting with others supporting even if they had a different idea going in. This often feeds into an illusion that everyone has the same opinion, creating greater optimism and loyalty to the view. As the view gains more strength, challenging views are often rationalized away. Different views can also be seen as a sign of disloyalty.

Herd behavior reduces internal stress and avoids conflict with others. It is simply easier to just go along and get along.

Herd Behavior when Investing

The desire to conform to the views of the larger group or consensus is often evident in the investment world. Would you feel more comfortable buying a company that has 20 analyst buy ratings vs another company that has 20 hold ratings? Probably. Twenty smart analysts who like the company is a pretty good company to hold. Yet, companies with fewer buy ratings tend to outperform those with the most buy ratings. Unfortunately, it is more stressful investing in companies that nobody likes. Being a contrarian is lonely.

In March of this year, the Canadian dollar was sitting at 75 cents. Among the six big banks, all except one were calling for the loonie to move lower by the end of 2017. Well done BMO, although they expected it to strengthen just marginally to 78 cents. Well it isn’t the end of 2017 but the C$ is already trading at 80.5 cents. Even anecdotally, reports or articles talking up a strong Canadian dollar were few and far between. The herd was certainly entrenched in expecting more loonie weakness, how wrong we all were.

When everyone is expecting one outcome such as the Canadian dollar moving lower or oil moving higher, it is often the case where things go the other way. And it is often cheaper to bet against the herd. If the demand to be long a given stock is pervasive, the cost of carrying a short position will be lower. When markets are doing well, the cost of portfolio insurance is often the lowest. Conversely when participants become fearful, portfolio insurance ends up costing materially more.

Non-commercial Futures Bets

The profitability of going against the herd can often be seen in the futures/options market. Following the non-commercial (aka speculative) futures contracts can often show periods when betting in one direction reaches extreme levels. And often it reverses rather quickly, as any change in direction of the price of the underlying assets hurries these speculators to cover their positions, adding to the speed of the reversal.

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