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

Why Investors Do What They Do: Diversification

In his classic book "Portfolio Selection" co-Nobel prize winner Harry Markowitz describes his topic as something other than securities selection. He suggests that a "good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies."

Diversification often involves numerous human emotions and misuse of it is often the result of some of the topics we have already discussed (loss aversion, narrow framing, anchoring and mental accounting with herding, regret, the impact of the media and optimism all as yet discussed). But diversification is a way to avoid being wrong. It is a way to avoid regret. And when you are wrong, you tend to be really wrong.

These feelings of "wrong-ness" are often the result of events beyond our control. Non-economic influences can derail the best efforts of an investor along with weather, military actions, even the health of the President. As Markowitz suggests: "Uncertainty is a salient feature of security investing".

In order to avoid too many economically obscure references to diversity we will boil the discussion down to two theories: the expected utility theory and the case-based decision theory. The first theory suggests that if the investor is indifferent to an investment, in other words they are so similar that she/he doesn't care either way, that this actually becomes a form of risk aversion and hardly ever produces good long-term satisfaction with those choices.

In the instance of Case-based decision theory, Mohammed Abdellaoui offers the following from his book "Uncertainty and Risk": "it is assumed the decision-maker can only learn from experience, by evaluating as act based on its past performance and on the performance of acts similar to it." This leads to chance decisions.

But what is often overlooked is that not only do you decrease your chances of being wrong, you by default increase your chances of being right. Diversification will spread the risk and as a result of that, may allow you to miss the next hot stock or mutual fund. Because it is impossible to pick the future based on the past - recall the reminder that past performance might not play a role in future results - diversification makes the chances of getting some of the hot property but not all of it.

Consider this simple question: if Rome is located between 41°54' North Latitude, which American city lies at a similar latitude - Boston, Atlanta or Miami? Most folks when asked this question go with either Miami or Atlanta and do so with more than reasonable assurance that they are correct. But Boston, with 42° 21' 29" N is actually the closest by comparison.

Unfortunately, as Robert Hagin author of "Investment Management" points out that people when people make investment mistakes - something that can afflict both professionals and non-professionals, they fail the old adage of "a problem is not what up don't know; it is what you do know."

The most difficult part of investing is removing guesswork and the wishful thinking you may have for the act. Not easy by any means. But much easier if you don't overthink the act of spreading your risk.

Next up: Herding

Why Investors Do What They Do: Mental Accounting

Many of us can rattle off the balance in our set-aside accounts, the small stashes of money we allot for some special purpose. These accounts, whether they be for a down payment on a house or a vacation have been designated for something and when you mentally account for this money, you put a barrier around your access to it.

These are essentially illiquid accounts - at least in your mind. This type of thinking and the ability to strictly categorize is a special talent that many of us have and some of us need to work on. If you are able to keep even so much as a general budget of your household, you are probably using this kind of separation technique to make sure ends meet and the other accounts you have set-aside do not become victims of a small loan.

Retirement accounts, even those with restrictions on how you may access the principal amount you have contributed (penalties for early withdrawal, tax consequences) are good examples of this kind of behavior. Setting aside money to grow and adding to it on a regular basis is mental accounting. These kinds of accounts are often of the traditional 401(k) and IRA variety. It should be noted that one of the major selling points of the Roth IRA and Roth 401(k) is the access you have to your principal.

Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past. This is a cost trade-off that you make using this type of accounting error. Another example might be a bond fund that entices investors with a high yield but the underlying investment is losing capital.

(This last example is why there may be a flaw in the thinking that we overload a portfolio with dividend paying investments at the end of our careers. Once we begin drawing down the underlying investments, the dividends will also fall and this will lead to a quicker drain on the account.)

Much of this has to do with our love affair with our investment picks. Only the most hardened among us can engage in the cold-calculations that stock pickers really employ. Listen for the insincerity when a talking head on television begins a conversation about an investment with "we really like this stock...". That is, until something changes.

Mental accountants ignore these warning calls and often miss selling winners when they are winners and even worse, selling losers when they are losers. This throws the whole diversification within a portfolio out of whack. While we are still working, it pays to focus how we bracket our investments. Keep in mind that studies have proven beyond a doubt, bets on long shots increase as the last race approaches.

If you find evidence that an investment has changed, and some suggest that loss aversion plays a role in this type of mental reasoning, you need to reposition your portfolio. This is not as hard as it seems nor does it require as much time as you might think.

It does however require you open your statements when they come each quarter or look at them online once a month. Set-up a Google alert for each underlying investment (a good retirement account should have no more than eight mutual funds and as little stock as possible) or build a sample portfolio at anyone of the sites that provide the free service. At the first hint of doubt, investigate and make a decision on what you should do with the whole of the portfolio as the benchmark, not the performance of the individual holding.

Next up: Diversification