Becoming a Better Investor: Curbing The Herding Effect

Following the crowd may make an investor feel better, but it might not work to advantage.

A True Story

At Club Iguana in NYC, things are happening. The music is pulsating, the dance floor is full and bodies are gyrating. As the activity reaches full peek, the disc jockey makes an announcement. It was as though he said, “There’s a fire.” Every single person on the dance floor rushes toward the back of the room where there incidentally is an exit. No one was left to continue the rotate, twist and turn.

Fortunately, the announcement was benign. The jockey said, “There’s face painting at the back.” Upon hearing this, every one of the 26 eight-year-old girls attending the birthday party ran madly to the single face painter located in the rear. If her paint table had not protected her, she could have been knocked over. The disc jockey had to make another announcement, “Not everyone can have her face painted at the same time; some of you will have to come back to the dance floor.”

The women were acting like lemmings. They were “herding” In short, they were imitating one another.

What is Your Story?

The Dow is over 21,000. Now, it is adult investors who appear to be herding, i.e. now beginning to buy stock because everyone else has done so. Though it is true that the market may not have peaked, certainly there are few good values to buy.

Whether you are an eight-year-old rushing to have her face painted because all her friends are doing it, or a forty-eight-year-old investor buying stock because everyone else has, the label is the same — herding. The result and its significance are different, however.

In the case of the young face painter, little is lost. For the older investor, though, the freedom to think independently about what she/he wants from her/his portfolio is wasted, a more significant event. The latter can result in loss of money and emotional distress.

Curving the Herding

A step forward in avoiding and controlling “herding” is to use asset allocation. Gary Brinson, Randolph Hood & Gilbert Beebower showed (Financial Analysts Journal, 1986) that a significant percent of portfolio performance is due to asset allocation. Simply put, this means diversification of investments over different asset classes to achieve a certain level of return at an acceptable risk. It is the scientific way to invest for the long term. Also, rebalancing a portfolio periodically, usually no more than once a year, keeps it in equilibrium during bull and bear markets, even when you don’t know where the market is going to go. For more, please see Preparing for Investing Unknowns.

What Should You Do?

To determine your asset allocation initially, you need to ask yourself:

What is my risk tolerance? Can I still sleep at night if the market goes down 20-30%? If not, asset classes need to be weighted toward those that provide less downside risk.

What is my time line? How old am I and when do I need the money? In general, the older someone is, the less risk that is advisable in her/his portfolio.

For more on asset allocation see: http://www.sec.gov/investor/pubs/assetallocation.htm

After asset allocation is determined, and there are many models that can be found in books as well as the Internet, the chosen portfolio needs to be rebalanced occasionally as stated earlier.

Warren Buffet on Herding

As Warren Buffet says, “You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right — that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else.”

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