Smart crowds & herd behaviour

Big market falls and high volatility are too easily dismissed as mindless herd behaviour.  But, might these moves actually be telling us something useful?  Can we distinguish good crowd behaviour from bad?  Behavioural finance offers some clues on how meaning might be extracted from the current market chaos.  It points us to examining the insights that are driving the price moves, rather than just calling it a blind panic.  The crowd might have spotted something that most analysts are missing. If so, the August market lows could be revisited soon.

 Surprisingly, it can make sense to pay attention to the crowd, even when it seems irrational.  The issue is not necessarily that other individuals may be smarter, but that someone else might spot a key change first.  Before the August crash in the Dow, a few observers questioned the July US consumer “rebound”, noting that car showrooms were still full of slow-moving stock.

 Cynics deride sell-offs.  Nobel Laureate, Paul Samuelson, said that “Wall Street had predicted nine out of the last five recessions”.  In fact, a new study by UBS, has assessed the real predictive value of a fall of more than 17% in the S&P500.  Since World War II, the market was right nine times, five warnings were wrong, and another two recessions were simply not forecast.  However, the market’s recent record is much better – none of the mistakes happened in the last decade. Market moves can predict the economy: the crowd often makes sense.

 Some investors try too hard to ignore the crowd.  Last month, when the S&P was down 11%, a poll of strategists showed they were as confident as ever about their end year targets.  The average forecast was 17% higher.  It sounds robust, but we should question this – even though the fall and rebound was exactly what happened in 2010. 

 The recency of last year’s experience could be influencing strategists’ expectations.   Humans latch on to patterns, and this sort of repeat is the easiest forecast.  Some strategists even said they were not changing as a matter of policy, lest it be seen as a “reactive mindset”.  But, there are times when it is right to respond to what others are doing.  Indeed, in turbulent conditions, where the environment is changing rapidly, a crowd may get to the underlying truth first.

 Signals of new trends can come from surprising areas.  It could be easy for an individual, or even a single investment organisation, to miss these sources.  The challenge is to balance what one knows or believes against the possibility that the market might actually be capturing useful new information.  At the root of the summer’s market fall, were new concerns; global growth prospects, Eurozone bank problems, and the US budget.  Politics and macro-economics are poorly captured by analysts compared with company research.  August’s poor US data caught most analysts by surprise.  Investors need to recognise that their trusted information sources can, at times, simply be behind the curve.

 Not all rapid market falls represent information cascades, where the wrong signals are amplified.  In 2007, bank shares were weak technically, showing real fear – despite confident reports from bank executives.   This persistent selling reflected concerns that were emerging from unconventional sources.  Yet, the crowd picked up on the submerged information, and ignored the predominance of buy recommendations. The banking crisis was better signalled by technical analysis than by fundamental investors using more conventional public information.

 Understanding crowd behaviour is an important aspect of behavioural finance.  And, light has been shed on this from a surprising source.  Studies of social animals such as honey bees, fish shoals and ants highlight the conditions needed for smart crowds, rather than a herd mentality.  In effective crowds, individuals collect information independently, but are quick to pick up when another has better signals. 

 Following the crowd can be rational behaviour, particularly when new threats are emerging. Research has shown that investors do tend to place more importance on crowd wisdom than their own private judgement when the environment is moving fast.  This mirrors behaviour in the animal kingdom. Swarms fleeing danger should follow the crowd 60% of the time, but spend the other 40% searching out their own escape routes.  It shows that we should pay some attention to what others are doing, even if we think we are smarter.

 We should not be so quick to dismiss “herd mentality” in a sell-off.  New information might be driving the adjustment to share prices.  Waiting for conventional sources – analysts and company executives – to revise their outlook could mean missing the best chance to protect capital.