Some Thoughts on Herding

June 20, 2010 in Markets

Yesterday, I came across a post by Jason Zweig on the Intelligent Investor blog.  The post basically outlines how humans are hardwired to herd, and thus we see it quite often in the financial markets.  This isn’t news to any student of the market and I agree completely.

I disagree, however, with the conclusion that he makes:

Thus, if you buy individual stocks, you should note which way the herd is moving—and go the other way. You should get interested in a stock when its price gets trampled flat by investors stampeding out of it. The list of new 52-week lows is a rough guide to what the voting machine has been trashing lately. Then run your own weighing machine, studying the company’s financial statements, products and competitors to determine the value of its business—while ignoring the current price of its stock. And make a permanent record that thoroughly details your rationale for making the investment. That way, you set in stone exactly where you stood before the herd began trying to sweep you away.

In my opinion this advice in dealing with the herd is far too simplistic. Betting against the herd can be quite profitable at times, but can be disastrous other times.  In fact, buying stocks at all time highs has a very attractive return distribution according to an interesting paper by Black Star Funds, Does Trend Following Work on Stocks:

Sean Park, a former trader and now an early stage financial technology investor often describes his investing strategy as “Skate Where the Puck Is Going To Be”.  I think this conclusion better fits the natural herding behavior in markets.  In markets, at all times you want to be in front of the herds next move.  As trends can often times persist, some times this involves a position amongst the herd with healthy skepticism of the underlying fundamentals and belief system of the pack.  Herds can quickly become mobs and trends can reverse sharply, thus other times a position in opposition of the herd is prudent with an awareness that you may be stepping in front of a stampede.

Investors must be aware of the state of the herd, the fundamental dynamics underlying both the herd and the counter-herd, and craft an investment strategy that takes advantage of the herds next move, not that herds are often times wrong.