Herding is detrimental in the world of investment

SERIOUS MONEY:THE INVESTMENT world is one of the few arenas in human life that has the capacity to make smart people look dumb.

Indeed, some of the finest minds through history have been humbled by the financial markets, including the scientist Sir Isaac Newton in the “South Sea Bubble” of 1720, the celebrated author Mark Twain in the silver fever of 1863, not to mention the Nobel laureates Myron Scholes and Robert Merton following the collapse of their ill-fated hedge fund, Long-Term Capital Management, in 1998.

Even some of the most adulated business luminaries on this island came unstuck as the property bubble imploded and levelled both their financial and reputational capital.

How could an entire nation be seduced to participate in such a dangerous and ultimately damaging love affair with bricks and mortar? The field of neuroeconomics – a new discipline that combines new technologies in neuroscience and tools in psychology to explain the decision-making of economic man – provides important clues.

The brain is the most important organ in the human body and is designed to interpret information and direct activity towards rewards and away from danger.

It accounts for roughly 2 per cent of the body weight of a typical adult human, yet, despite its relatively small size, the brain consumes about one-fifth of the oxygen and, hence, calories in the human body.

It should come as no surprise that analytical thinking in the conscious mind burns up neural resources. As a result, the brain has evolved to conserve energy and resorts to intuitive reasoning or “gut feel” when making decisions. Almost all human decision-making takes place unconsciously and the analytical processing system is employed only when absolutely necessary.

The fact that the brain economises means that most decisions are made before the conscious mind is even aware. Indeed, the subconscious mind processes half a million times more information per second than the conscious mind. Emotions, the subjective feelings that serve as traffic lights for the brain and elicit rapid stereotyped behavioural responses, are the brain’s default mechanism when humans make decisions.

The intuitive processing system is the product of millions of years of evolution so human emotions and decision-making skills have remained essentially unchanged for centuries. Indeed, Daniel Goleman, author of the best-selling book Emotional Intelligence, writes that “in terms of the biological design . . . the slow, deliberate forces of evolution that have shaped our emotions have done their work over the course of a million years; the last 10,000 years . . . have left little imprint on our templates for emotional life”.

The glacial pace at which evolutionary change takes place means that intuitive reasoning is likely to be better equipped to solve the problems that faced hunter-gatherers in the African savannah 200,000 years ago rather than the complex challenges of the modern information age.

This is particularly true of the investment world where problems are complex, while information is incomplete, ambiguous and constantly changing. Under such circumstances, the intuitive system typically overrules even deliberately formed intentions, leading to sub-optimal decision-making.

Individuals’ decision-making is subject to cues inherited from the ancestral environment and one of the most dangerous in the investment world is undoubtedly the desire to be part of the crowd.

Herding, which in a biological sense is the tendency for some species to seek safety in numbers, is easy to understand from an evolutionary perspective. Being part of a group and taking cues from others reduced the risk of falling prey to a predator on the Serengeti for example, whilst simultaneously increasing the odds of a successful hunt for meat. Furthermore, imitation of others was a successful strategy that enabled the rapid transmission of good ideas throughout a group of humans, while monitoring the actions of others also yielded important information about resource availability and mating potential.

However, though herding proved beneficial to our ancestors in the African savannah, the same behaviour typically proves detrimental in the investment world. The human instinct to imitate others can lead to the mispricing of assets as individual investors base their decisions on expert opinion and slavishly make investments simply because the experts expect the uptrend to persist.

Herding can result in a dangerous asset bubble as more and more investors jump on the bandwagon. However, the collective behaviour of the stampeding crowd causes a decline in population diversity, such that even a small decline in demand can have an outsized negative impact on market prices. The inevitable result is a destabilising crash.

It is clear that the herding phenomenon was an important factor behind the Irish property bubble and subsequent bust. A dangerous drop in population diversity occurred as expert opinion from the financial institutions to the regulator and even political parties argued that price increases were supported by fundamentals, and ruled out the possibility of a hard landing.

The instinctive desire to herd was given impetus by such expert opinion, which served to dull individuals’ normal sensitivity to risk or danger. Individual investors’ reward-seeking system, which releases dopamine – the brain’s “pleasure” chemical – was thus placed in overdrive with an attendant increase in risk. The dangers were under-appreciated and since simply matching expectations produces no dopamine kick, more and more risks were taken as an entire nation began to resemble a cocaine addict that requires an ever larger “fix” to yield the same effect.

The lessons from neuroeconomics are clear. Optimal financial decision-making requires self-awareness and emotional management, or as Socrates declared: “know thyself”.

charliefell.com