Monday, June 29, 2009

Why Investors Do What They Do: Herding

It is okay to look at the winners and losers, for mutual funds they are posted quarterly while stocks are posted daily. It is also okay to want to align yourself with the winners while foregoing the losers. It is only called herding when the winners see a large influx of new investors because of past performance, an indicator that is usually disclaimed as not indicative of future results. But the actual act of buying into any investment with the hope that the current top is not actually a top but a lower rung on an ever-rising ladder.

The cautionary warnings about just such a strategy often fall on deaf ears. Few folks have the patience to wait out an investment that has performed well in the hope that if they shift their investment to a high-flying fund, they will do even better. There are several things to consider before doing this and lessons to be learned if you have ever done something like this.

First off, funds that maintain a steady amount of growth usually take all of the cost factors into consideration. Among those factors, turnover stands out. Many high flying funds that find themselves on the top ten lists, at least in the short-term, usually have very high turnover - which means, higher than average trading costs, a new manager that has shifted priorities or simply a manager rearranging where they are as the quarter or year ended. Turnover incurs trading costs that are directly passed down to the shareholder. Sometimes, they even create a taxable event if the fund has sold numerous winners from the portfolio to reposition the fund for another round of winning.

Those steady growth funds are often referred to as value funds. Value funds tend to look for undervalued, better performing companies. Growth funds, which dominate the marketplace, tend to look for companies that have more potential than proof of success. This leads to a higher underlying risk and increased turnover risk. While they may actually grow in value, these types of funds often undercut those profit numbers with higher than average fees.

Secondly, mutual fund investors often fail to consider the size of the fund or the size of the companies that the fund invests in. While there are thousands of companies to chose from, the majority of these companies are actually much smaller, more volatile because of their size and although they offer growth, they seldom have the long-term track record to prove investment-worthy.

And lastly, investors who herd seldom take into account the geographic area of those underlying investments. While the world faces the same economic challenges, the recovery will vary from one region to the next. Some parts of the global economy may recover more quickly (such as emerging markets) while more industrialized nations such as the US will take longer to embrace the economy recovery.

In Emilio Barucci's book "Financial Markets Theory" he describes herding as an "effect [that] arises because other decision makers may have information important for the decision maker". He points out that "fund managers care for their performance because their compensation, their career and the probability of being chosen in the future by investors depend on their performance relative to an exogenous benchmark or to the performance of other fund managers." He notes that the presences of these features, while not saying competition is bad, results in investor herding.

It should also be noted (and this comes as a warning as well) that herding is most prevalent after a crisis. But herding is usually based on a weaker set of reporting requirements, opaque regulations, somewhat lower accounting standards, reputation and most importantly, potential. Alan Lewis wrote in his 2008 book "The Cambridge Handbook of Psychology and Economic Behaviour that there is absence of knowledge on the subject when it comes to long-term results or opportunity suggesting that there are "deeper, structural underpinnings of investor behaviour [sic], including their investment beliefs and the way investors justify their behaviours to others."

Next up: Regret

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