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Herd Behavior in Investing

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 group-think. 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 than another company that has 20 hold ratings? Probably.

Twenty smart analysts who like the company makes for 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 Canadian dollar 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.

 

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Disclaimer

Charts are sourced to Bloomberg unless otherwise noted

This material is provided for general information and is not to be construed as an offer or solicitation for the sale or purchase of securities mentioned herein. Past performance may not be repeated. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please seek individual financial advice based on your personal circumstances. However, neither the author nor Richardson GMP Limited makes any representation or warranty, expressed or implied, in respect thereof, or takes any responsibility for any errors or omissions which may be contained herein or accepts any liability whatsoever for any loss arising from any use or reliance on this report or its contents. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

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