Primer | When investors become sheep

There was a time when Orkut was the place to be. Today, it’s Facebook – to an extent that you are an outcast if you are not on it.

This makes sense in networking – if you like to connect with people, you would be where people are. As more people join, it gets more attractive for others to follow suit. More attracts more. But this doesn’t make sense in fashion, where low-waist jeans are “trending”; or in music where Despacito is now on everyone’s playlist; or even in politics where people who are sitting on the fence eventually vote for the party they think is winning.

The Bandwagon effect

Humans have an underlying need to conform and belong – that’s the reason societies and communities thrive. Also, when we think we don’t have enough information about a subject, we follow the crowd – if everyone is doing it, it must be the right thing to do, correct? Well, no. In 2006, some 400 sheep of a flock fell to their deaths in Turkey after they followed the one which tried to cross a deep ravine. Such herding behavior is displayed by humans too, and is referred to as the bandwagon effect. When people keep hopping onto the bandwagon in investing, it leads to asset bubbles, be it the Tech bubble of the late 1990’s or the Bitcoin bubble more recently. Regardless of the asset class, the bubble eventually bursts and takes all the sheep down with it.

The pitfalls of Momentum Investing

Bandwagon effect is also observed in individual stocks. Investors buy into a stock which has been rising, expecting it to rise further, while exiting stocks that have been falling. In effect, they chase trends and often end up buying high and selling low, which is the exact opposite of what one hopes to achieve while investing. Consider an investor who had been tracking Vakrangee. Seeing the stock rally up to double its price in the year leading up to September 2017, he would be tempted by greed. Wanting to get a piece of the cake for himself, say, he invested Rs 1 lakh. Within three months, his capital would have nearly doubled to Rs 2 lakh. So far so good. But, in the six months that followed, he would have lost not only his profit, but most of his initial investment as well. At the end of this roller-coaster ride that he had entered with Rs 1 lakh, he would be left with only Rs 14,000.

Unfortunately, this is actually a very common style of investing called momentum investing. Even professional money managers chase rising stocks and exit unpopular ones. It handsomely rewards the portfolio managers but only until the market reverses. Then, their portfolios crash. The key to making this approach work without witnessing significant drawdowns and accompanying heartaches is knowing when to exit. But, that’s a herculean task in itself – there is virtually no way of knowing when the rally will turn on its head, especially when our greed blinds us to everything else. After all who wants to jump off a happy bandwagon and risk being left behind?

So what’s a good investment strategy?

Thankfully, the solution is within arm’s reach – Quantitative Money Management. When it comes to the bandwagon effect, quantitative investing offers a two-pronged solution. Firstly, as mentioned in previous articles, its research phase involves extensive backtesting over long periods in history to get a reasonable sense of how the strategy is expected to perform in different market scenarios. The backtest period includes market upturns as well as downturns, and a momentum strategy has been seen to invariably suffer during downturns. This means that when the manager decides to go ahead with real money in his momentum strategy, he would have backtested signals to help identify when a reversal is in the offing and pivot accordingly.

Secondly, once a quantitative strategy is past the research phase and into the live phase, it runs on auto mode with minimal human interference. So, when the signal indicates a reversal during the live period, it is no longer in the hands of the manager who might have, otherwise, decided to hang on to the rising stocks a little longer in the hopes of milking the rally further. This leaves no room for greed taking the portfolio down in the event of a reversal. That said, any strategy is only as good as the underlying signals which drive it. So, before deciding to invest, an investor must look for the hallmarks of a good investment strategy – robustness of the backtest, sound investment philosophy, transparency of results, and honesty in execution.

Next Monday, we will explore the endowment effect – how what we already own seems more valuable than it really is.


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