The herd mentality - and how to avoid it

, talk to Nimesh Shah, director and chief executive, Parag Parikh Financial Advisory Services, about the psychology of investing

It is amazing how stock investors get taken in by the herd mentality. When markets are surging furiously, everyone wants to buy stocks; when the markets begin to plummet, investors flock to sell their holdings with or without any valid reason.

In essence, investors often behave irrationally and that is why a study of psychology can help one get a better perspective.

Psychology is increasingly being acknowledged as an integral part of financial decision-making. This week we bring interviews with two experts - DR Richard Geist and Robert J Shiller - on markets and the psychology of investing.

The interviews were done in Boston by Shah who attended the seventh congress on the psychology of investing, held in November last year.

The three-day meet brought together a faculty of seminal educators and leaders in the fields of psychology and finance to explore the interface between human emotions and financial decision-making.

Dr Richard Geist
Faculty of Harvard Medical School's department of psychiatry

Dr Richard Geist specialises in the psychology of investing. Geist is the president of the Institute of Psychology and Investing where he consults with brokerage firms, money managers, financial planners, small companies and individuals.

He publishes a micro-cap market newsletter, Richard Geist's Strategic Investing, and is the co-editor of The Psychology of Investing. His thoughts on the psychology of investing have been quoted extensively in international publications.
Excerpts from the interview:

In this age of excessive information and advice, what would be the general behavioural rules that investors should follow?

In the era of information overflow, it is impossible to have in-depth knowledge of every sector. So I think it is best if investors try to match their personality style to a market niche and stay within that chosen areas of competence and emotional style.

In your book Investor Therapy you talked about 'thinking small' and the fact that trained financial analysts, especially large-cap analysts, often function from the left side of the brain which represents the sequential, intellectual, rational and analytical side. What approach do you recommend?

Regarding small-cap investing, analysts and portfolio managers who want to participate in this sector must learn to think more with the right side of their brain - intuitively, inductively and wholistically.

The reason for this is that entrepreneurial chief executives tend to think this way, and the only way to evaluate small companies without a lot of financial data is to get inside the head of management to try to assess their vision of the future and then make judgments about their ability to grow their business, given their particular products and services.

How does 'herd mentality' impact investors?

As humans, we are hardwired to seek connections to others. When investing under conditions of risk, we experience enormous pressures that silently challenges or stresses our sense of self and forces us to question our judgment.

That is when individual expression becomes weighted in the direction of the herd. When unable to mobilise ways of modulating tensions and in face of volatile markets, investors tend to seek guidance and direction from people whom they look up to.

But at this stage of sense of self-strain, the connection with others can be more akin to relationships of political or rock-star groupies, following cult leaders blindly into oblivion.

Investors accept the wisdom of the herd while the paradoxical fact is that successful investing requires us to stand firm against the herd despite the weight of evolutionary drives.

How do investors free themselves from the 'herd mentality syndrome' that has taken an almost permanent place in today's investing world?

Avoiding herd mentality is essential for success in the market. The best way for individual investors is to invest in an interpersonal context - alongside a small and trusted group of people who can challenge and question their decisions in a non-threatening manner.

Warren Buffett and (his close friend and advisor) Charles Munger have this sort of relationship which has worked well over many years.

Many sophisticated and institutional investors use the short/medium-term trading philosophy to make profits. What do you propagate?

There is probably no one correct way to invest. Some people perform better with a short-term orientation; others do better with a long-term orientation. My own preference is for the long-term.

But I think what we have seen is that the more investors experience anxiety - whether political, economic, or personal - the more short-term focused they become.

This is also exacerbated by the fact that electronic signals can go around the world in one eighth of a second; so people's lives have been speeded up to the point that immediate gratification has become the norm globally.

The growing shift towards short-term and quarterly announcement of results by companies and funds tends to distort the long-term investing philosophy. What is your view on this?

I do believe that quarterly performance statistics just exacerbate the problem and forces companies to focus on the short-term rather than the long-term.

We would be much better off if companies were judged on a yearly - rather than quarterly - basis. After all it typically takes a start-up company about four years to reach a reasonable and dependable growth rate.

Emerging countries have semi-closed economies. How do you expect them to shape up?

My views on emerging markets are complex, but to oversimplify, I think technology is going to lead to more and more folks having information and jobs, and thus increased spending power will become a factor in the next few years.

And I believe that emerging markets will over the next decade overtake developed countries in economic growth.

What is your advise for investors in India?

The message for investors in India is to begin to understand the implications of psychology for decision-making and to focus on the enormous technology possibilities that are taking place there.

Robert J Shiller
Professor of economics at Yale University

Robert Shiller is a renowned name in the world of economics. Shiller, who received his doctorate in economics from the Massachusetts Institute of Technology (MIT) in 1972, authored popular books related to finance and economics, including Market Volatility, Macro Markets: Creating Institutions for Managing Society's Largest Economic Risks, Irrational Exuberance (translated into 15 languages, the book was on The New York Times non-fiction bestseller in 2000) and The New Financial Order: Risk in the 21st Century.

At the seventh congress on the psychology of investing held in Boston, Shiller talked about how the Efficient Market Theory has given way to the Behavioural Finance Theory due to its inability to explain excess volatility.

He pointed out that markets are inefficient and that investors make irrational decisions when investing. He said price changes in stocks sometimes occur for no fundamental reason and they may occur just due to mass psychology.

Also, the level of volatility in stock markets cannot be explained by any variable in the efficient market model in which stock prices are formed by the present discounted value of future earnings.
Excerpts from the interview:

You are bearish on the US markets and not heavily invested in equities right now. Can you explain your reasons?

The US stock markets are still highly priced and there is a possibility that they could fall dramatically.

In the US, it seems the "irrational exuberance" has been blunted somewhat and people do not have the enthusiasm that they used to have. People are holding on to their old strategies and are happy. The price-earnings ratios are still very high in the US.

In the US, one has to be underweight in equities as it looks overpriced. The other alternatives, too, are risky.

The problem is that long-term bonds have come down a bit and they are still pricey as interest rates are low. There is a potential of loss there, too. Real estate is no different.

It has been booming for long and we can easily see a downturn. So all the major asset classes in the US are showing weak prospects now. I tend to worry most about the stock markets though they all are vulnerable. This only means that one should diversify.

Emerging countries like India, China, Russia and Brazil have seen a lot of positive enthusiasm from foreign investors and markets in these countries have shot up dramatically. As an economist, do you share this optimism?

The US situation does not necessarily apply to other countries. I have a lot of long-term optimism for India. It seems the economy is growing very well. And they are linking better to the world.

That means the underlying economy should do very well. However, I do not follow the stock markets in India to know whether it is appropriately responding.

The India stock markets are very shallow and tend to go up sharply with increasing flows. The recent bull run has got a lot of support from the massive liquidity created due to large inflows from foreign institutional investors. Do you foresee any behavioural anomaly in such situations?

It has always happened in Asia. In 1997, the Asian financial crisis was brought on by a sudden change in opinion amongst foreign investors who pulled their money out. So, capital markets can be flighty and it is a risk.

However, the time and pattern in which Indian stock markets have moved matches that of the US. It is curious how these time patterns extend around the world. Economies are strengthening around the world and markets are reacting, or may be overreacting, to that.

Institutional managers are becoming increasingly short-term oriented, while one generally advises investors to invest with a long-term view. How does one bridge this disconnect?

Investors say they are investing for the long-term. However, when it comes to making decisions on where to put their money, investors are somewhat whimsical.

They pull out of mutual funds after a few bad quarters and switch to those that display better performance. It is a very common human error and no one is to blame for this.

We see that the focus of market players is increasingly getting short-term and stocks move more on quarterly results than on long-term fundamentals. How does one rectify this situation?

Too much focus is on earnings. And not as much on other general evidence about the long-run trajectory of the firm. Managerial compensation is tied to stock prices and, hence, there is too much emphasis on it.

Managerial compensation should probably be based more of a judgment on how good a job a person is doing. You don't trust the market on this. Because the market is responding to earnings and earnings are not very realistic indicator of the long-run trajectory.

You have maintained that humans are not geared for investing. Why do you say stock investing is so difficult?

Well, investing involves judging the long run and there are far too many factors that influence investing in the long term. It is very easy for an individual to get distracted by some evidence that is being publicised a lot.

Besides, one has to take into account the fact that everyone else is seeing the same media stories and that the market may be overreacting to some piece of information.

There are really thousands of factors to be considered, making it difficult to judge. It's like you got be a historian, a business analyst and an accountant and use all those skills to judge in the long run to be a successful investor. Humans may not be geared for that.

What is your advise for Indian investors?

Stay out of America! The stock market here is vulnerable. At around 16 price-earnings for the index in India, the valuation sounds okay. They are much better valued than the US.

My gut feeling is that India would do well. India has been growing and riding behind China and it is catching up. Indians are capable but have been held back for a long time. Now it is time to catch up.

(Nimesh Shah is director and chief executive, Parag Parikh Financial Advisory Services)