How Herding Behaviour in Stocks Creates Overreaction

One of the fundamental cognitive biases that clouds are decision making on buying and selling stocks is herding. We are wired to aspire to be on a winning team and we will gravitate are decision making to associate ourselves with winning or hot investment trends. We will be more motivated to buy stocks that are culturally and economically popular, much in the same light as Keynes observed. From an institutional perspective, financial analysts, forecasters, and economists, will further exasperate the behaviour by giving higher ratings to hot companies as well as inflated forecasts and consequently lower ratings and forecasts when the environment is weaker.

In the book, Misbehaving: The making of behaviorial economics, Richard Thaler cites research by Werner F.M. De Bondt who observed that companies that do well for several years in a row gather an aura implying that they are a “good” company and will continue to grow rapidly. They will be considered the “it” company. We’ve seen them: Apple and Research In Motion come to mind. On the other hand companies that have been losers for several years become tagged as “bad” companies that cannot do anything right. Think of it as a form of corporate stereotyping. As investors, we will collectively gravitate towards and away from these companies.

If you combine this stereotyping with forecasts that are either too extreme, you have a situation that is ripe for mean reversion. Those “bad” companies it turns out are not as bad as they look and are on average are likely to do surprisingly well in the future. Meanwhile, the “good” companies may turn out as real duds.

We were assuming that by driving the price of some stock up or down enough to make it one of the biggest winners or losers over a period of several years, investors were likely to be overreacting to “something”.

Essentially following the herd mentality or sentiment that overreacts on a specific sentiment about a company or the overall market or economy can lead to outcomes that will go the opposite direction. Thaler cited some empirical research that backed up the concept.

If you looked at portfolios backdated over 3 years, loser portfolios consistently did better than winner portfolios. Over a 5 year period, loser portfolios outperformed the winner portfolio by 30 percent. Winner portfolios did worse than the market by 10 percent.

Based on 3-year formation periods for winning and losing portfolios the average beta for the winner was 1.37 and for losers it was 1.03. So Winner portfolios were actually riskier than loser portfolios.

Value stocks, which invest in stocks that are out of favour by the broader market, either with very low P/E or extreme past losers predictably outperform the market. This is true but the timing is not perfect. There is no Estimated Time of Arrival on when this will occur.

In a nutshell, Thaler observed that,

“When prices diverge strongly from historical levels, in either direction, there is some predictive value in these signals. And the further prices diverge from historical levels, the more seriously the signals should be taken. Investors should be wary of pouring money into markets that are showing signs of being overheated, but also should not be expected to get rich quick by successfully timing the market. It is much easier to detect that we may be in a bubble than it is to say when it will pop and investors who attempt to make money by timing the market turns are rarely successful.”

The last sentence is key as even though you are observing a bubble or extreme herd mentality in investment behaviour, it can take a long time for that behaviour to shift. That bubble can stay a bubble for a longer time (and hence you are leaving money on the table) or that malaise can stay a malaise for a longer period of time (and hence your losses may grow further). According to the father of value investing, Benjamin Graham, “Undervalutions caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants.”