The Herding Instinct Is Powerful

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Readers of the financial press have undoubtedly seen recent articles describing investors’ retreat from actively managed portfolios and migration to passive investments that attempt merely to match market indexes. The latter have done better in recent years. Because investors are invariably trend followers, that phenomenon is very understandable. When markets go up or down for several years in a row, investors have a predictable habit of connecting the dots, creating a trend line and projecting it into the indefinite future. Collectively we expect good news to be followed by good news and bad news by more bad news. Unfortunately, those expectations lead the majority of investors to buy high and sell low.

Mutual fund purchase and sale data demonstrate the perverse buy high/sell low tendency quite clearly. Near market highs, news reports are typically positive and confidence is high. Investors who may have missed much of a rally see how others continue to profit by participating. The siren call to get invested becomes increasingly compelling the longer a rally lasts. Conversely, when markets have declined for an extended period of time, the news invariably turns gloomy and forecasts become increasingly negative. As market prices descend, growing numbers of investors reach their pain tolerance limits and lighten or eliminate their risk exposure. As a result, there are far more fund purchases at high prices and redemptions near the lows. This tendency plays itself out across all sectors of the investment spectrum. And it’s not just a recent phenomenon.

In the twentieth century, it was very common for investment managers to assume the prime responsibility for adjusting investors’ asset allocations. Many investment managers were categorized as Tactical Asset Allocators (TAA), whose approach was to move assets to those investment areas deemed safest and/or potentially most productive. For decades, many of those firms practicing the TAA approach did an excellent job of protecting and growing client assets. The decade of the 1990’s, however, produced a major shift in investors’ attitudes. There were precious few market declines of any consequence, so managers who allocated away from risk almost inevitably were penalized for their caution, not rewarded, as they had often been in the past. As the decade wore on, TAA firms became scarce. Those that survived largely migrated to a more fully invested, fixed allocation approach. The good times lasted so long that even the most patient investors opted to join the crowd and assume greater and more permanent risk exposure. Unfortunately, this shift was just before the 50% stock market decline from 2000 to 2003, when properly executed asset allocation would have been most appropriate.

The tendency for investors today to forego caution and simply go with the flow of free money and rising stock prices is remarkably similar to attitudes prevalent around the turn of the century. Tomorrow is unknowable, but there is substantial reason to expect reversion to the mean in the years ahead as the excesses of the free money era are eventually eliminated. Beware of herd mentality. Remember: what we get to keep is typically what we have at market lows, not what we have at the highs.