Guppy See, Guppy Do
At first blush, biologist Lee Dugatkin appears to be a guy with way too much time on his hands. The focus of his research is the apparently esoteric question of how female guppies select mates. As it turns out, female guppies have a genetic preference for bright-orange males. But when Dugatkin arranged for some females to observe other females choosing dull-colored males, the observing females also selected the dull males. Surprisingly, in many instances female observers overruled their instincts and chose instead to imitate other females.
Why should anyone care about how female guppies pick their partners? The answer gets to the core of a lively debate about whether animal behavior is shaped solely by genetic factors or if culture plays a part. Dugatkin’s work demonstrates that imitation—a form of cultural transmission—is clearly evident in the animal kingdom and plays a central role in species development.
Certainly, too, imitation is a vital force with humans. Fashions, fads and traditions are all the result of imitation. And since investing is inherently a social activity, there is every reason to believe that imitation plays a prime part in markets as well. Most investors and businesspeople have fundamental philosophies that are supposed to define their behavior—much like genetics shape guppy mate selection. But we know that for money managers and guppies alike, imitation sometimes has a substantial influence on decision making. So is imitation good or bad for investors?
Feedback—negative and positive
Well-functioning financial markets, like other decentralized systems, rely on a healthy balance between negative and positive feedback. Negative feedback is a stabilizing factor, while positive feedback promotes change. Too much of either type of feedback can leave a system out of balance.
The classic example of negative feedback in markets is arbitrage. Indeed, arbitrage is a central plank in the case for efficient markets. For example, if the price of a security diverges from its warranted value, arbitrageurs buy or sell the appropriate securities in order to close the price/value gap. Negative feedback resists change by pushing in the opposite direction.
Positive feedback, on the other hand, reinforces an initial change in the same direction. The snowball effect, cascades and amplification are all examples of positive feedback. While investors often view positive feedback as undesirable, especially when it leads to a runaway process, it isn’t always bad.
When is positive feedback good? Well, it can help promote a smart decision. For instance, early investors in a promising new industry may encourage others to invest, sparking the industry’s growth. Positive feedback can also get a system out of a bad situation. In nature, a “follow-your-neighbor” strategy may allow a flock of birds to elude a predator. Analogously, it can help investors flee a bad investment.
Follow the Ant in Front of You
Imitation is one of the prime mechanisms for positive feedback. Momentum investing, for example, assumes that a stock that is rising will continue to rise. If enough investors follow a momentum strategy, the prophecy of a high price becomes self-fulfilling. Most investors view pure imitation with some misgiving, belying their often-imitative actions. But imitation often has a rational basis. Consider the following cases, for example:
Asymmetric information. Imitation can be very valuable when other investors know more about a particular investment than you do. We all routinely use imitation in our day-to-day decision making, allowing us to leverage the -specialized knowledge of others.
Agency costs. Many money management firms must make tradeoffs between maximizing the performance of the investment portfolio (long-term absolute returns) and maximizing the value of the business (by collecting assets and fees). Companies that choose to maximize the value of the business have an incentive to do what everybody else is doing. This imitation minimizes tracking error versus a benchmark.
Preference for conformity. As Keynes said, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Humans like being part of a crowd, as the group often bestows safety and reassurance.
So positive feedback is desirable under some circumstances, and investor imitation can make sense. But positive feedback can also lead to excesses.
Financial economists describe herding as when a large group of investors make the same choice based on the observations of others, independent of their own knowledge. In effect, herding occurs when positive feedback gets the upper hand. Given that markets need a balance between positive and negative feedback, such an imbalance leads to market inefficiency. This is in contrast to the classical view that investors trade solely on the basis of fundamental information.
Determining exactly how much positive feedback is too much may be an impossible task. Extensive scientific studies of innovation and idea diffusion reveal that there is typically a critical threshold, a tipping point, beyond which positive feedback takes over and the trend dominates the system. The relative frequency of bubbles and crashes strongly suggests that there are consistent discrepancies between price and value.
The market is not the only decentralized system that exhibits suboptimal imitation. For example, there is the fascinating case of army ants. A group of worker ants, which are essentially blind, sometimes separates from the colony. Since no individual ant has any idea how to relocate the rest of the colony, all of the ants rely on a simple decision rule: follow the ant in front of you. If enough individuals follow the strategy (i.e., they reach the tipping point), they develop a circular mill, where ants follow one another around in circles until death (see graphic). One such mill persisted for two days and had a 1,200-foot circumference and a two-and-a-half-hour circuit time.
Of course, for the ants imitation is hardwired genetic behavior, not cultural. Investors, in contrast, have the ability to think independently.
However, Charles MacKay’s famous words from more than 150 years ago remind us that avoiding the imitation trap is an age-old problem: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they recover their senses slowly, and one by one.”
Herding from the grapevine
George Soros is the most prominent investor to explicitly cite the role of positive feedback in his investment philosophy. Soros’s theory of reflexivity argues that there is positive feedback between a company’s stock price and its fundamentals and that this feedback can lead to booms and crashes. Soros’s strategy was to take advantage of these trends by either buying or shorting stocks.
The finance literature also reveals a number of examples of herding among investors:
Mutual funds. Russ Wermers found evidence of herding among mutual funds, especially in small--cap stocks and growth-oriented funds. He found that the stocks the herd buys outperformed the stocks the herd sells by 4 percent during the subsequent six months.
Analysts. Ivo Welch shows that a buy or sell recommendation of a sell-side analyst has a significantly positive influence on the recommendations of the next two analysts. Analysts often look to the left and to the right before they make their recommendations.
Fat tails. Econophysicists, using simple herding models, have replicated the fat-tail price distributions that we empirically observe in markets. These models provide a much more convincing picture of market reality than those that assume investor rationality.
In markets, a symbiotic relationship between positive and negative feedback generally prevails. If all speculators destabilized prices, they would buy high and sell low, on average. The market would quickly eliminate such speculators. Further, arbitrage—speculation that stabilizes prices—unquestionably plays a prime role in markets. But the evidence shows that positive feedback can dominate prices, if only for a short time. Imitation can cause investors to deviate from their stated fundamental investment approach and likely provides important clues into our understanding of risk. Next time you buy or sell a stock, think of the guppies.
Michael Mauboussin is chief investment strategist at Legg Mason Capital Management and adjunct professor of finance and economics at Columbia Business School.