Misery Loves Company

The Wall Street Journal ran a piece this morning about the recent “bloodbath” in performance for a handful of hedge funds.

It seems that many of these funds were involved in the same trades, and when you add leverage into the mix, a declining market can lead to terrible performance if everyone rushes to the exit at the same time:

“It’s a bloodbath out there,” said Brad Alford of Alpha Capital Management, an Atlanta-based investment firm. He attributed some of the losses to funds crowding into the same stocks and rushing out at the same time. “There are some awful numbers.”

Mom and pop investors are usually the ones singled out for herd behavior by chasing performance in the latest and greatest, but the herd mentality happens with regularity with professional investors as well.

You can probably attribute much of the recent hedge fund carnage to the fact that so many of these funds use similar research and trading platforms. Many of these portfolio managers and analysts have been trained under similar schools of thought. In a market that’s been on a tear for over five years, there are bound to be crowds attracted to those areas of the market with perceived value.

It’s almost becoming difficult to be a contrarian in today’s market because there is so much competition for investment ideas. This can harm these large funds when they share a similar investment process for idea generation. Eventually this can lead to big losses in crowded trades when the market reverses or the thesis proves incorrect.

What’s amazing to me is that these hedge fund blow-ups seem to occur on a regular basis. Herding is a phenomenon that even the most intelligent investors can get caught up in. Most of the time the crowd is actually right in the markets (they have to be to move prices), but imbalances can occur when the herd mentality goes too far.

One of my favorite psychology books of the past few years, Mindless Eating: Why We Eat More Than We Think, has some great studies on human behavior when it comes to following the crowd when making poor decisions.

For instance, it’s estimated that we are forced to make in upwards of 200 decisions each and every day when it comes to food choices. Also, it’s estimated that 95% of all people who lose weight on a diet end up gaining it all back. One of the reasons for this is that we follow along with the group, even when we’re trying to eat right. The number of people we eat with has a huge impact on how much we eat:

On average, if you eat with one other person, you’ll eat about 35% more than you would otherwise. If it’s a group of 7 or more, you’ll eat nearly 96% more or almost twice as much. With four people you end up eating about 75 more calories than by yourself. We tend to mimic the speed and amount that others around us eat.

We tend to lose our self-control when we see others around us acting a certain way. It becomes a self-fulfilling prophecy when we look to others for cues about how to act in these situations.

There was another study from Mindless Eating that was interesting from an investing perspective. Researchers performed a study on a two pieces of day old chocolate cake. Although they were the same exact cake, one was simply called “chocolate cake” while the other one was labeled “Belgian Black Forest Double Chocolate Cake.”

They found that people not only chose the second option more often, they also rated that it tasted better as well. This is why restaurants come up with fancy names for the food on their menus. Fish eggs doesn’t quite have the same appeal as caviar. Calamari sounds much better than squid.

One of the ways Wall Street coaxes the herd into making bad decisions is by packaging similar products in fancy-sounding funds. My rule of thumb is the more extravagant the fund name, the bigger the chance you are getting ripped off by high fees or a complex product.

The best remedy for the herd mentality is to have a plan. Crowds can’t think for themselves but an individual can. Crowd behavior is generally not governed by any sort of rules; investment plans are.  Therefore, the easiest way to avoid getting swept up in the crowd is to have a rules-based process in place.

Misery Widespread at Hedge Funds (WSJ)
Mindless Eating: Why We Eat More Than We Think

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  1. Tony commented on Oct 22

    I agree with your view that herd behavior in the idea generation process could be due to convergence of education background and information sources. The likely effect is greater volatility, ie., larger moves (trend and reactions) which took shorter time to form.

  2. Dylan commented on Oct 24

    Great piece. Certainly agree with the point that a rules based approach is key. That can apply to all walks of life I feel, obviously our choice of when to apply it. Most would likely agree that ‘heuristics’ might not be best when choosing between friends for example. However, like in more appropriate places where heuristics should be applied (finance and investment), it’s inevitable that some kind of bias will rear its nasty head every now and then. It’s inevitable that a person may apply rules when deciding between friends every now and then.

    • Ben commented on Oct 24

      Agreed. Emotions are not always bad, just in certain situation. Sometimes it helps to use your emotions when making decisions. All about finding the right balance.