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Showing posts with label herding. Show all posts
Showing posts with label herding. Show all posts

Thursday, 26 March 2020

Anchors A-weigh!

Lost At Sea
In these uncertain times, as the Covid-19 virus moves across the planet, we’re seeing markets yo-yoing with wild price fluctuations on almost a daily basis. Jumps or falls of over 5% are commonplace. This is not normal market behaviour.

However, it isn’t unusual behaviour either – in the context of market history. Anyone who remembers 2008 or 2000 or even 1987 will have seen this before. This is what happens when investors lose their anchors – with nothing to attach to they follow each other, and the result is very predictable and not at all pretty.

Thursday, 24 July 2014

Y is for Yawn Effect

The Yawn Effect occurs when you yawn in response to someone else yawning. In fact you can even get your dog to do it (or get coerced into yawning by your pooch). Yawning is contagious, and contagion is an inevitable unconscious consequence of people interacting with each other – and, as usual, when we behave automatically as investors it doesn't make for a good financial outcome.

Wednesday, 24 October 2012

Seasonally Affective Investing Disorder

Not Not Die Out

Behavioral bias occurs in all sorts of odd ways, but basically can be traced back through evolutionary history to when humanity’s survival depended on deep co-operation and the invention of sewing.  Our ability to cope with the huge changes in weather conditions experienced over our short history defines our species: we didn’t go extinct.

It shouldn’t therefore be particularly surprising that we’re unconsciously affected by environmental conditions: there was a time, not so long ago, when nothing else mattered.  Now, cosseted by central heating and air conditioning, we’re remote from our material world but, it turns out, for investors our material world is not remote from us.

Tuesday, 14 August 2012

Minding the Chastity Belts: Fiduciary Duties and 900 Pound Lemmings

 
"Today investors herd around short-term investment strategies adopted by other prudent experts who manage similar funds. This has unleashed a flock of 900-pound lemmings into the economy."
Crusading Fiduciaries

If you were a medieval knight embarking on the twelfth century equivalent of a Mediterranean cruise, aka going off on the Crusades, you would have needed someone at home to take care of the castle, the gold and the chastity belt keys.  That person was known as a fiduciary.

The fiduciary’s duties were those of loyalty and prudence; perfect qualities for today’s equivalent, the financial advisor.  Sadly most financial advisors don’t see themselves in this light.  Even sadder, those that do are usually to be found in that herd of 900-hundred pound lemmings that constitute the mass of behaviorally compromised investors. Time for a re-think, all round.

Thursday, 12 April 2012

Facebook Friends Can Make You Poor

Talk, Talk, Talk

Economists have had an extraordinary new idea. They’ve noticed that people communicate with one another and this has opened up a new line of analysis. Maybe these social interactions are somehow important in investment decisions?

Alright, enough sarcasm. The likely involvement of social interaction in causing the diffusion of investing ideas has been around for a while, but is only now catching up with the social networking phenomena. Behind this lies an insight that’s obvious when you’ve had it, but not before: the better your returns the more likely you are to broadcast your results.

Tuesday, 30 August 2011

Investment Analysts, Sunk By Deepwater Horizon

Flawed Analysis
“BP has a systemic problem with its culture that runs deep.”
There are unlikely to be any readers of this article unaware of the disaster surrounding BP in 2010 when their Gulf of Mexico based oil drilling rig Deepwater Horizon lived up to its name in dramatic and tragic circumstances. Since then many people have pointed fingers and made accusations but the quote above, by Hersch Shefrin, comes from his book, Ending the Management Illusion, based on an analysis of the behavioral flaws apparent in BP’s management, and written two years before the disaster at the Macondo Prospect.

Yet while Shefrin was able to identify the potential problems at BP ahead of the game not only did this not alert investors to the dangers of investing in BP it also failed to jolt oil sector analysts into any kind of action at all. And, frankly, if analysts can’t tell the difference between an oil major taking excessive safety risks and one that isn’t, what the hell’s the point of them?

Wednesday, 11 August 2010

James Randi and the Seer-Sucker Illusion

Illusion is not Forecasting

Every morning before he left home the illusionist James Randi used to take a piece of paper and write on it “I James Randi will die today”. He’d then sign and date it and slip it in the pocket of his jacket. Had he died, of course, the world would still be full of credulous believers insisting that he was a genuine psychic seer. We smart investors laugh at such fools, of course.

We shouldn’t, though, because every day we’re the victims of people just as clever as Randi and without any of his good moral sense. Every day, across the world, people forecast the unforecastable and predict that markets will boom, or bust, or stagger sideways like a drunken sailor. Eventually one of their predictions comes true and gullible people everywhere equate this with foresight when, in fact, the forecaster has simply been slipping a note in their pocket each morning. In a world where everyone predicts everything occasionally someone’s going to be right.

The Cowles Study

The evidence that most forecasters are simply practising the illusionist’s sleight of hand has been mounting for a very long time. Way back in 1933 Alfred Cowles published a paper on Stock Market Forecasting which “disclosed no evidence of skill in forecasting”. When he extended this study in the 1940’s he commented:
“The wording of many of the forecasts is indefinite, and it would frequently be possible for the forecaster after the event to present a plausible argument in favor of an interpretation other than the one made by the reader”.
Gosh, do tell.

Cowles’ research used the forecasts as a basis for actually making investment decisions – so a completely bullish forecast was assumed to cause an investor to invest 100% of their funds in the market. Computing the compounded results of acting on these forecasts led to a series of observations, the gist of which is that the forecasters exhibited no aptitude for forecasting. Indeed, they underperformed the market and were consistently, by a factor of 4 to 1, on the bullish side:
“The persistent and unwarranted record of optimism can possibly be explained on the grounds that readers prefer good news to bad, and that a forecaster who presents a cheerful point of view thereby attracts a following without which he would probably be unable to remain long in the business of forecasting”.
A 50-50 Bet

Given that markets were down around as much as they were up in the period under study and that forecasters were nearly always bullish it’s fairly easy to see that they’d be right about 50% of the time. Which is what Cowles found. In fact if you take a view that most forecasters are always bullish you can take a view that most forecasters will look like geniuses in a bull market and bozos in a bear market without exhibiting any particular skill in either direction. Similarly the smaller number of forecasters who are usually bearish will obtain the reverse position. To whit: forecasters forecast nothing, they’re simply signing their death certificate each morning.

In the current environment, therefore, we might expect to see a few consistently bearish commentators looking as though they can outwit the markets. Nouriel Roubini, aka Dr. Doom, has recently pointed out that his s track record of forecasting major moves in the recent past is very good – having called five out of six movements correctly. Only the five called correctly were all downwards and the other one was the mother of all rebounds.

Roubini is, by far, one of the most intelligent commentators on markets, but the point is that trying to figure out whether any recent record of success is attributable to skill or luck is pretty much impossible. So the question is: if forecasters are so useless why do people keep on using them?

The Seer-Sucker Theory

J. Scott Armstrong has come up with The Seersucker Theory to explain this. What he showed, through a wide range of examples taken from finance, psychology, medicine, etc was that forecasting success is not generally related to expertise over and above a pretty minimal level of competance In fact forecasting accuracy seems to drop once people get above a certain level of expertise. It’s not entirely obvious why this is but there are hints that confirmation bias is involved: seers are less likely to look for disconfirming evidence to cross-check their opinions than less confident semi-experts.

Meanwhile the seer-sucker theory states:
“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of suckers”.
Or: for every seer there’s a sucker. One reason for this might be to do with avoidance of responsibility on behalf of the suckers. All too often in situations involving risk and uncertainty “experts” are called in who have no realistic chance of making a better decision than anyone else: that’s the problem with uncertainty. It’s uncertain. It’s unpredictable.

Herds of Analysts

However, Hong, Kubik and Solomon in Security Analyst’s Career Concerns and Herding of Investment Forecasts have proposed an interesting variation of why analyst forecasts aren’t very good in general. Herding – the behavioural trait that causes investors to move in a given direction at the same time – is triggered by career related incentives. This, of course, is not generally a factor for private investors and therefore is often neglected in considerations about why professionals make their recommendations.

What they find is that younger analysts tend to herd more than their more experienced colleagues: less experienced analysts tend to be punished more heavily for getting their forecasts wrong so they have every incentive to stick with the crowd. In contrast older analysts, who have presumably built up their reputations, face less risk of termination. Basically if a younger analyst makes a bold forecast and gets it wrong they’re likely to lose their job, while doing so and getting it right seems to make little difference to their immediate career prospects.

Although the study implies that the more experienced analysts are more accurate forecasters it, unfortunately, doesn’t make clear whether they do any better than chance over long periods. If Cowles’ findings still stack up the probability is not. Either way relying on consensus forecasts by great stampeding herds of perversely incentivised analysts isn’t likely to yield great results. Look for the outliers and then analyse them: still no free lunches, just hints and intimations.

Give Me Stories, Not Facts

Of course, in writing this, I’m well aware that forecasters will carry on forecasting and followers will carry on following: McKinsey have just published another study confirming nothing’s changed. When the inventors of the crop-circle came forward to explain how they’d fooled scientists the world over with a bit of ply-wood they were almost universally ignored. James Randi has made a second career out of debunking mystical charlatans who prey on people’s gullibility. Yet still they believe and often react violently to having their illusions shattered. It’s as though we can’t grow up and face the real world: it seems that fairies, dragons, magic and mysticism are so much more attractive than the grim reality of credit card repayments.

And this is the hidden truth – we find stories more congenial than facts. Markets are driven less by fundamentals and more by tales of derring-do. Forecasters are story-tellers not diviners of the future. Like all authors of fiction we should enjoy them for what they are: just don’t confuse their narratives with proper investing.



Related articles: Investing With a Time Machine, Investment Forecasts: Known Unknowns, Real Fortune Telling

Saturday, 1 May 2010

Herd of Investors

Bovine and Asinine

It seems sort of obvious that investors, a generally bovine group when not in asinine mood, will tend to congregate in herds and then charge about randomly, often over the edge of the nearest cliff. If this is true, however, it poses a set of puzzles that it’s not clear that any of the current approaches to understanding mass market behaviour can properly explain.

Certainly this behaviour isn’t efficient in the sense of obtaining the right price for a security, because deciding what to do based on the person running about in ever-decreasing circles next to you doesn’t come close to propagating useful information. However, if investors are irrational in herds then this implies that somehow their behaviour is synchronised and it’s certainly not clear that the simple set of isolated psychological biases that analysts currently work with is anywhere near sufficient to explain this.