Prior to the recent market correction, Merrill Lynch surveys showed a record number of fund managers believed stocks were overvalued but a record number were also taking above-normal levels of risk, leaving their investors dangerously exposed when indices suddenly went south.
It begs the question: why is herding such a problem in financial markets?
Agreeing the US market is expensive and still choosing to own stocks smacks of a "cynical career-risk-driven position if ever there was one", high-profile GMO strategist James Montier argued in a recent note, adding: "I have been amazed by the number of meetings I've had recently where investors have said they simply 'have to own US equities'."
To Montier, this herd behaviour – that is, buying simply because others are buying, irrespective of the dangers – has echoes of 2007, when then Citigroup chief executive Chuck Prince famously defended loose lending policies on the basis that "you've got to get up and dance" as long as the music is playing.
However, herd-like behaviour is not only a symptom of overheated markets – it’s a notable feature in times of trouble, as past Merrill surveys show.
At the bottom of the global bear market in March 2009, most fund managers correctly identified equities as undervalued but nevertheless chose to underweight stocks.
At the height of the European debt crisis in June 2012, a record number of fund managers said Europe was the most undervalued region; instead of buying European stocks, they went to cash, with cash levels hitting their third-highest levels on record. In September 2013, fund managers agreed the world’s most undervalued stocks were in emerging markets, but they also said that emerging markets was the region they most wanted to avoid.
In other words, professional investors appear just as guilty as ordinary investors when it comes to herd-like behaviour.
In fact, they may be worse, warned the International Monetary Fund’s (IMF) Brad Jones in a 2015 report, Asset Bubbles: Rethinking Policy for the Age of Asset Management.
The rise of the institutional investment management industry “has coincided with three of history’s largest bubbles in the last 25 years”, said Jones, referring to the Japanese bubble of the late 1980s, the global equity bubble of the late 1990s, and the credit bubble of the mid-2000s.
Career risk
Jones did not believe that professional investors were clueless, saying the asset management industry is presumably populated with “the most sophisticated, well-resourced and rational speculators in the world”. Rather, he agreed with Montier that the problem is one of career risk.
In the short-term, it can be more profitable to side with the crowd than to go against it, so the fact that managers’ performance and bonuses are usually assessed on an annual rather than a multi-year basis make it “a key factor motivating herding”.
Worse, fund managers can lose clients and risk being fired if they refuse to buy into a bubble that keeps on inflating. This motivates institutional herding and “rational bubble-riding”.
In other words, “failing conventionally is the route to go”, as Warren Buffett once said. Lemmings may have a bad image, said Buffett, “but no individual lemming has ever received bad press”.
In contrast, fund managers who go out on a limb can pay a heavy price. For decades, author and contrarian investor David Dreman was one of the most widely-respected names in the investment business, but his decision to hold onto falling financial stocks resulted in him losing his job at the bottom of the global financial crisis in April 2009. Deutsche Bank justified its decision by saying Dreman's fund "had seen very weak performance for the fund over every major time horizon".
In fact, Dreman’s 2008 performance meant he had underperformed over one-, three- and five-year periods but his long-term record remained a superior one.
Similarly, underperformance in recent years has resulted in assets under management collapsing from $124 billion in 2014 to $74 billion today at Montier’s firm, GMO. This is not the first such episode. GMO’s cautious attitude during the technology bubble in the late 1990s resulted in its assets falling by almost 45 per cent, with several frustrated clients actually banning the firm from its buildings.
The "central truth of the investment business is that investment behaviour is driven by career risk" GMO founder Jeremy Grantham opined in a famous 2012 note. "Missing a big move, however unjustified it may be by fundamentals, is to take a very high risk of being fired. Career risk and the resulting herding it creates are likely to always dominate investing."
The same pressures influence analyst ratings. Herding is especially pronounced among younger analysts, note the authors of a 2010 paper, Herding Behaviour among Financial Analysts. Being wrong can be very costly when you’re young and at the start of your career, compared to an older analyst who has built a reputation over time.
The potential benefits of a contrarian stance (praise for being right) are outweighed by the potential risks (losing your job if you’re wrong or early). Given the “asymmetric” nature of this choice, it’s natural that analysts “will play it safe and herd”.
Stress hormones
Of course, career risk is not the only factor driving herd behaviour in financial markets. In recent decades, behavioural finance experts have documented innumerable cognitive and motivational biases that drive irrational investing behaviour.
Biological forces are also at play, according to the authors of an Israeli study published in the New Journal of Physics in 2014. People behave in a relatively rational manner most of the time, said Prof Eshel Ben-Jacob from Tel-Aviv University, but hormones secreted by the brain in times of stress change the way that reality is processed. The end result is that, in times of stress, people typically choose to follow patterns that are familiar, avoid making individual decisions, and become more herd-like in their behaviour.
This helps explain why herd behaviour is so evident in difficult times, as was evident last month, when markets dropped like a stone as investors rushed towards the exits.
The irony is investors rightly try and construct a diversified portfolio that will cushion the blow in hard times, but diversification “melts away in times of market losses”, to quote a separate 2012 study co-authored by Prof Ben-Jacob that examined market behaviour over a 70-year period. Correlations between individual stocks and the overall market soar when markets fall, resulting in a “diversification breakdown” at the very moment that investors are seeking protection.
Right now, the consensus is stocks will survive the recent scare and keep going higher. However, fund managers feel the bull market is in its latter stages; Montier points to January’s Merrill Lynch fund manager survey showing almost 70 per cent believe stock markets will peak at some stage in 2018. And yet, they’re taking above-average levels of risk.
Fully-invested money managers seem to think they can “get out before everyone else”, but this is “simply impossible”, says Montier, who compares it to a game of musical chairs where the competition gets fiercer as the chairs become increasingly rare.
George Soros famously warned that it is dangerous to go against the herd because one is liable to be trampled on, but going with the herd brings its own dangers, says Montier – namely, getting crushed in the eventual stampede towards the exits.
