Going Against the Herd

Though it may seem hard to believe, individual investors have an advantage over Wall Street pros during periods of increased uncertainty such as the current market environment. Everyone must contend with the powerful psychological force of "the social proof," in rising markets and in falling ones. There are additional structural features, however, that promote herding behavior on the institutional level that don't apply to the individual.

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By Brian Graney (TMF Panic)
March 5, 2001

Over the past few months, individual investors have watched a number of previously common stock market elements go right out the window.

For instance, no one seems to talk about "the next hot IPO" anymore. Can you name any of this year's IPOs? And how about those triple-digit share price targets of old? They're gone too.

At one point early last year, triple-digit price targets from analysts became so popular that it seemed every self-respecting growth stock on the planet was deemed to be worth at least $100 per share. And whatever happened to that George Gilder guy? Anyone heard from him lately? Or those bizarre "Be Bullish" Merrill Lynch TV ads, the ones that looked like trailers for the next Mission: Impossible sequel? Where did they go?

Given all the above, it seems quite a bit has changed in the investing world over the past year or so. However, that's not really the case at all. There are a number of underlying aspects to the market that will probably never go away. Uncertainty is one of these constants, if not the largest of them all.

Uncertainty didn't get much play a year ago when everything seemed rosy. It was still around, but was overshadowed by high-flying stock prices the way Faith Hill overshadows her backup band. Now, with the U.S. economy barely growing and earnings warnings coming in left and right, uncertainty in the stock market has become much more pronounced. Anytime you hear a market commentator complaining about a company "lacking visibility," that's Wall Street-speak for uncertainty. And investors are hearing that phrase a lot these days.

How investors on the whole choose to deal with uncertainty also hasn't changed very much, and likely never will. For the most part, we look to others to show us the way, and then we do what they do. This leads to what is known as "the herding instinct" or "the social proof," and it's just as common in the stock market as it is in other areas of life.

In his book Influence: The Psychology of Persuasion, Arizona State professor Robert Cialdini defines "the social proof" along the lines of a self-reflexive truth: "The greater the number of people who find an idea correct, the more the idea will be correct." In many instances, "going with the flow" is a good policy: Witness the trend toward market economies in developing countries, or the growth of community recycling programs. Human nature being what it is, however, the social proof can be carried too far sometimes. Cialdini has identified certain tendencies of crowd behavior that open up potential risks: 

"First, we seem to assume that if a lot of people are doing the same thing, they must know something we don't. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof." [Emphasis mine.]

Over the past decade or so, the social proof has generally served investors well. The idea that investing in stocks is the most effective way to build wealth over time has caught on and snowballed throughout society. Federal Reserve Board Chairman Alan Greenspan has in the past cited the "learning-curve response" of millions of Americans becoming aware of the benefits of long-term investing as one of the major changes in the market over the past few years. It is also evidence of the social proof at work. On the individual level, investors need only look back at their annual returns from their stock holdings over the later half of the 1990s to see how much the social proof has positively affected their financial lives.

Problems arise, however, when uncertainty creeps into the picture. As Cialdini points out in the previously cited passage, heightened uncertainty has a way of magnifying the power of the social proof. With uncertainty, the tendency of human beings to be much more sensitive to negative than to positive stimuli -- a major finding of the Prospect Theory research done by psychologists  Daniel Kahneman and Amos Tversky, among others -- also comes into play. Prices fall, people take a look at their paper losses, wince, and then join in on the selling.

This progression of events might seem like so much theorizing and psycho-babble if it weren't for the fact that herding behavior is actually wired into the financial system through the major institutions in the market. This is an important point. As State Street Bank's Avinash Persaud relates in his acclaimed essay "Sending the Herd Off the Cliff Edge" (.pdf file), there are three main factors that drive herding behavior in the financial markets, but two of them are structural in nature and only one is psychological:

"First, in a world of uncertainty, the best way of exploiting the information of others is by copying what they are doing.

"Second, bankers and investors are often measured and rewarded by relative performance, so it literally does not pay for a risk-averse player to stray too far from the pack.

"Third, investors and bankers are more likely to be sacked for being wrong and alone than being wrong and in company."

The first cause of herding cited by Persaud is nothing more than the social proof as earlier defined by Cialdini. However, this is the only herding element that applies to individual investors. The other two elements are occupational hazards for "investors and bankers," Persaud's reference to the big financial players of the world. They don't apply to small investors.

So, in terms of staying out of potentially detrimental herding behavior in the stock market, the individual investor is at a comparative advantage versus the pros. This is something to keep in mind as the general psychology of the market shifts and the benefits from the past social proof-driven market unwind. It may sound strange at first, but in periods of increased uncertainty, it is the individual investor who actually has the upper hand.

Brian Graney is still mourning last year's demise of the sock puppet. You can see his holdings on his profile page. The Motley Fool is investors writing for investors.