John Maynard Keynes is quoted from 1936’s “The General Theory” to describe herd mentality of professional money managers. Keynes, the father of Keynesian Economics writes,
It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional, and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short-run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.
You can think about Keynes comments through the metaphor of Woody Harrelson’s character in the 1992 classic White Men Can’t Jump which I may have watched 50 times as a teenager. Harrelson, a hustler dresses sloppily to hide his skill on the basketball court. He cares more about winning than looking like a basketball star. In the end both Harrelson and Snipes characters need each other to win a championship. Similar themes are discussed in a Malcolm Gladwell Podcast discussing Rick Barry’s underhand or “granny” free throw shooting. Where are the fictional Harrelson characters or Rick Barrys of investing? Which investment manager would rather be right than liked (noted as career risk, closet indexing/low active share, etc.)? See another Gladwell podcast highlighting quantitative investment management shop AQR.
Investment managers particularly fundamental or quantitative investors cannot be herd followers. If you’re going to beat the market you have to be different than the market or you should just index. Indexing is perfectly fine, just don’t pay for active management to get index or less than index performance. Herd mentality can have negative outcomes from both professional and individual investors alike from inflated valuations crashing after prices have been bid up through market timing. Please see an intraday chart on Tilray (TLRY) for a recent example. Consider this tweet that is part of an amazing thread from Jim O’Shaughnessy:
While a herd mentality may not be beneficial to investors I’m familiar with one area where a the herd mentality can be used to your advantage. I’m sure there are others. But, my example is with cattle. Cattle are herd animals that seek the comfort, safety, and socialization that the herd provides especially when challenged by a predator. For millennia cattle have been the prey and have adapted characteristics that allow for them to be managed in a domesticated fashion that takes advantage of their herding characteristics.
Some examples follow:
- Farmers can “train” the whole herd of cattle to move and be placed in a field fairly easily through positive reinforcement by offering some feed or even just an open gate into a pasture with a fresh strip of grass. Ask a cow and she’ll confirm that the grass is always greener on the other side.
- When working with cattle in close quarters they clump into one tight grouping. If you get one cow going in the right direction the rest of them will follow. Generally, cattle move in the opposite direction of the cattleman as pressure into the cow’s flight zone is applied.
- If a farmer wants to get the herd moving they can walk from side-to-side to get the cattle in motion and tightly grouped. By taking advantage of pressuring the cow’s flight zone and releasing the pressure a seasoned cattlemen can direct the herd with their movements.
- Cattle group together into a herd when challenged by predators to protect a new born calf from a lurking coyote or vulture.
For a cattleman being able to use the herd mentality to his or her advantage is a major tool for efficiently managing their livestock.
Are there any good uses of the herd mentality for investors? Knowledge of the herd mentality’s existence in investing is a start and can be used as negative signalling to alert investors. If valuations in the stock market have gotten expensive relative to historical norms this might be a sign of the herd mentality at play in the market.
The chart below (thanks ROIChristie) from JP Morgan Asset Management (3rd Quarter 2018) shows the historical forward (next 12 months earnings expectations) since 1990. We might say the 2000 Internet Bubble or the era of Irrational Exuberance demonstrated herd mentality as funds were forgetting their mandates (style drift) and investors were pilling into anything with a strong track record and a large tech weighting. We shouldn’t forget that career risk for professional investment managers as expressed in the earlier Keynes quote is a major reason of herd behavior, as well as FOMO.
But, using the chart where are we today? We can see that we’re not as inflated as we were at the end of January 2018 because both earnings and analyst’s earnings expectations have increased while stock returns moderated. However, we are slightly above the historical forward P/E average and approximately 20% than the historical average CAPE.
What does that mean for investors? Will the market go higher from here or crash? On the short-term I don’t know, but on the long-term and based upon history I believe that the market will both crash at some point and will move higher from today. This tells us that at historically higher valuations there is a decent chance that equity returns will be more muted than during times when valuations were lower and the economy was improving. But, lest we get confused, just a reminder that timing the market by using valuations doesn’t necessarily indicate when a crash might occur.
The takeaway for individual investors with that information is multifaceted. If returns will be lower over the next decade investors will need to save more to meet their long-term goals. It might also mean that stocks are less desirable than they once were relative to bonds over the prior decade as interest rates on bonds increase. Investors should also revisit their asset allocations to make sure they can stomach a decline of 20 – 30% or reconsider their behavior in 2008-2009 and adjust accordingly. If asset allocation between stocks and bonds have drifted significantly from the targeted asset allocation as a result of stock outperformance portfolio weightings should be revisited. Finally, review your investments to see if you have non correlated assets that will provide a cushion if equities fall.
Remember that the herd mentality exists in both the stock market and out on the range. It can be a negative signal for the market as valuations have expanded and investors are piling in seeking to time the market. It potentially means returns may be lower in the future. For cattlemen the herd mentality is useful in accomplishing goals and daily activities on the farm. Just don’t get the two confused especially in a bull market. Meanwhile some of my girls say “Hi!”