Herding behaviour. How independently do investors think?
Issue #14
Hello all, welcome to the latest issue of Markets and Macros by TradingQnA, in this issue;
Weekly market wrap
Herding behaviour. How independently do investors think?
Climate change, food security, and farmers and more…
Weekly Market-wrap
A quick look at how the markets performed in the week ended 2nd December.
Herding behaviour. How independently do investors think?
The central assumption of economics is that humans are rational Homo economicus, i.e., people consider all available information and make the best decisions. Starting around the 1970s-80s a new breed of economists started poking holes in this assumption. They showed that humans aren’t perfectly rational animals as commonly assumed, and they do a lot of dumb things. So much so that, today, we have this giant map of all the stupid things we’re capable of.
This is what’s known today as behavioral economics and behavioral finance.
Standard economic theory assumes that people will make the best decisions in their self-interest. By that logic, people shouldn’t really make a lot of investment mistakes, but we know that that’s not true.
Let’s take the example of herding—one of the most common mistakes investors make.
Herding is when investors blindly and mindlessly follow others like sheep. Pause here for a second and think back about the last time you blindly followed someone and it ended badly.
How did it end?
I’d guess not well.
Theoretically, we’re not supposed to be sheep. We also delude ourselves into thinking that we don’t behave like sheep—but we are. We display herding behavior in many facets of life. We follow fashion trends, we go to trending restaurants and bars because of others. It’s the same with investing.
So why does it matter, you ask?
Apart from all the obvious reasons, herding can lead to distortion in the markets.
Remember, we are not supposed to herd like sheep. We’re supposed to be all-knowing and all-rational. This is kind of what’s also called the Efficient Market Hypothesis (EMH). In other words, the prices of financial assets reflect all available information, and predicting the prices and outperforming the markets is hard, if not impossible.
While EMH is an elegant theory, it’s not an ironclad rule. We keep seeing this in all the dumb things that investors do and in all the bubbles and manias.
There’s rich literature on how investors herd, but the behavior varies across countries and types of investors. This also shows how behavior is sensitive to cultural forces, traditions, market structure, and other factors.
Woochan Kim and Shang-Jin Wei looked at investors in South Korea. They found that foreign institutional investors outside South Korea exhibit more herding than foreign institutional investors and individual investors inside South Korea.
Khorana, Ajay, and Chang analyzed five different markets and found varying behavior across markets.
We examine the investment behaviour of market participants within different international markets (i.e., US, Hong Kong, Japan, South Korea, and Taiwan), specifically with regard to their tendency to exhibit herd behaviour. We find no evidence of herding on the part of market participants in the US and Hong Kong and partial evidence of herding in Japan. However, for South Korea and Taiwan, the two emerging markets in our sample, we document significant evidence of herding. The results are robust across various size-based portfolios and over time.
What about India?
Aniket Ranjan, Suman Sourav, M. Sreeramulu, and Shahbaaz Khan found this when looking at the Indian market from January 2019 to March 2020.
Overall, investors in the Indian Stock Market do not exhibit herding behaviour, except for some evidence of herding activity in respect of mid-cap stocks. Further, the investors’ mimicking behaviour is more noticeable during days with negative market returns and days with net outflows of foreign equity investment.
This is a short observation period, but are investors becoming smarter? Time will tell. We’ve seen other examples of herding in India in stocks like Yes Bank, Zomato, etc. As prices fall, retail investors herd more. The one common truism is that herding behavior increases when markets are volatile.
Let’s explore this topic a little more.
One other irrational thing that’s common across the markets is the investor preference for lottery stocks. These are stocks that have a small probability of a large payoff.
Preference for lottery stocks
Is it the right way to build a stable future? Financially and emotionally.
No.
What causes this behavior?
The biggest reason is that we are bad at thinking about probabilities. Let’s think this through. Lottery stocks broadly tend to be penny stocks and growth stocks–stocks with poor fundamentals. For such stocks to create wealth, they have to become fundamentally great stocks. What are the odds of that happening? Almost zero. So if the probability of a terrible stock becoming great is almost zero, nobody should buy such stocks logically. Yet we do.
Here’s why:
It feels like a shortcut to becoming rich by a windfall gain. We hear about someone making millions out of a penny stock or something like dogecoin and hope to duplicate that.
If you buy a stock that’s Rs 2, the maximum you could lose is Rs 2 per share but the upside is unlimited. This is how most investors think.
Investors are sensation seekers — they like the thrill of frequent trading and taking financial risks.
Stocks that are in the limelight attract investors. These could be stocks in the news for the wrong reasons, stocks with loud analyst coverage, stocks peddled by influencers, or stocks popular on social media. We saw this in a recent insider trading case involving a CNBC anchor. The volumes of the stocks mentioned on the show would immediately shoot up. Then there was the case of stocks like GameStop and AMC Entertainment.
Source: WSJ
Lottery stocks attract greater buying interest and hence increase retail net buying because of herding. This drives up the prices higher relative to their fundamentals, resulting in lower or negative future returns.
As a thumb rule, if you don't actively track the markets and you hear about some stock or news from your social networks, it’s usually too late.
“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” — Blaise Pascal
We also have a great gift for self-delusion. We equate information to smarts or wisdom. Knowing a lot or reading a lot of news can lead to an inflated ego which leads to investing mistakes.
We are also susceptible to the representation heuristic.
When we’re making decisions, by default, our default mode of thinking is to look for patterns from our past experiences. There’s a reason for this. We hate uncertainty, and in a real sense, uncertainty hurts us physically. We evolved to do anything to reduce this pain of uncertainty, and one of the mental shortcuts is to rely on what we know, what we saw, read, or heard last. For example, a clickbaity article is more memorable than a boring analysis. This gives us an illusion of knowledge.
Larry Swedroe, the head of the financial and economic research office for Buckingham Wealth Partners and a prolific author, summed it up best in a recent podcast:
So you have a few stocks that are called lottery stocks. You hit the lottery if you bought and own Microsoft or apple and held it for a very long period of time. Those stocks make up for the many stocks that disappear. In fact, a very small percentage of stocks even last 30, 40, or 50 years. Every year a significant number of stocks disappear. Unfortunately, most investors— I would say simply because they're human beings—tend to be overconfident. It doesn't matter what the question is; you ask them are you a better than average driver or a better than average lover? It doesn't matter either way 90% of people pretty much say they're better than average, which of course cannot be so when it comes to picking stocks. Of course, they think they're better than average makes them overconfident. If you're overconfident, why do you need to diversify because you can pick the stocks that'll outperform uh the evidence says not true
Why does all this matter?
Let’s put all this together. Remember that we started this post by noting that these behavioral mistakes can cause market distortions? When done right, you can take advantage of the mistakes of others to create wealth.
The momentum effect or relative momentum is a pervasive and persistent anomaly in financial markets. Momentum is the tendency of stocks that are going up to keep going up and stocks that are falling to keep falling. There are various explanations for the momentum anomaly, but one of the reasons is herding. Momentum occurs when investors overreact and herd into stocks. When people herd, it pushes up the price, attracting more people until it reverses. Over long periods of time, momentum investing has delivered excess returns–above-market returns.
One other pervasive and persistent phenomenon is time-series momentum or trend following. This is similar to the momentum effect. The idea behind time-series momentum is that the past returns of an asset can predict future returns. One of the explanations behind trends is that they are caused by investor herding. Like momentum, trend following has persisted over long periods of time across markets.
Another well-known anomaly in the financial markets is the low volatility effect–the tendency of low-volatility stocks to outperform high-volatility stocks. Intuitively, this anomaly makes no sense. We’re all taught that high risk = high returns. One explanation for this anomaly is the investor preference for lottery stocks. As investors pile into high-beta stocks, they end up overpaying for these stocks, which reduces future returns. On the flip side, stocks with low volatility or low beta stock perform well because they are neglected.
You may ask, what do I do instead?
Investing is a long-term game. It needs study and research. You can’t hope to get consistently lucky without putting in the hard work, and you also need a generous dose of luck.
Know who you are
Knowing yourself is the beginning of all wisdom. — Quote attributed to Aristotle.
If you see the first image, it has 188 biases. Looking at it is depressing and can easily give you the feeling that we are almost useless. Which is why you often hear some version of the saying, retail investors will always lose money. But just having enough awareness that you are human and will make mistakes can go a long way in helping you become a better investor.
The idea behind reading about behavioural finance and knowing about various biases isn’t to remember all of it. It’s to understand that you can make a lot of mistakes and to build an investing plan and strategies that take that into consideration.
Dive deeper
— Written by Abhinav and Bhuvan
Climate change, food security, and farmers
The poorest and the most vulnerable people and countries were disproportionately impacted by COVID-19. The Food and Agriculture Organization (FAO) estimated that since 2019, 150 million more people are suffering from hunger.
As the world was slowly starting to recover from the pandemic, the Russia-Ukraine crisis dealt another profound shock to food security around the world. But food security around the world will dramatically worsen due to climate change. According to International Food Policy Research Institute (IFPRI) projections. 90 million Indians could be pushed toward hunger if climate change worsens due to declining crop yields and disruption in the food supply chains.
Let's talk about the decline in agricultural production. There are 2 main issues here:
Disruption of rainfall patterns and low yield of Indian crops.
Disruption of rainfall patterns
40% of the agriculture, 67.79 million hectares out of 180, in India is rain dependent.
Almost 69 million hectares of cropped area was lost in the last 6 years. 33.9 due to floods and heavy rainfall and 35 due to draughts and scanty rainfall. IMD analysis of this year’s monsoon revealed that only 40% out of 703 districts in India had average rainfall.
Let's see how a change in rainfall patterns affects food production.
Recently we saw rainfall just as the paddy was about to be harvested. This prolonged the harvest season, leading to higher input costs (pesticides) and a decrease in production as well, ranging between 2-5%.
Low crop yield
The problem with low yield is not just that farmers' incomes will be lower, but if you look at it from a larger perspective, you can see that there are so many other losses too. More land, water, and additional resources are wasted.
India also suffers from significantly low yields on several key crops:
Soy yields in India are three-four times lower compared to the US and Argentina, while mustard yields are almost half compared to canola grown in Canada (mustard and canola belong to the same Brassica genus). India imports both varieties of edible oils to meet its large domestic shortfall.
The US exported $27 billion worth of soybeans in 2021, while India’s edible oil import bill surged to a record $19 billion in the year to March 2022. This is the cost of a lower yield.
While we are still debating on GM foods, other countries have adopted GM foods and are getting spectacular yields. But things are changing. BT cotton might lose its place as the only GM plant allowed for cultivation in India as the Supreme Court is hearing a plea about allowing GM Mustard for cultivation in India.
A reason for lower yields in India is inadequate research and a poor patent protection regime that disincentivizes the private sector. I'm just going to leave the following facts with you:
Between 2010 and 2020 the overall public expenditure on agriculture decreased from 11% to 9.5%.
The central budget for agriculture research is a paltry ₹8,500 crore (for 2022-23), less than 0.25% of the farm sector GDP.
Are there any other ways to increase yields apart from better seeds?
Yes.
We could promote sustainable agricultural practices like mulching, crop rotation, cover crops, and zero-till, which aids carbon sequestration, besides adding organic matter and improving soil moisture.
In this modern era, we must also push for precision and technology-enabled agri practices. We need to shed the old adage that industrial or technologically advanced agriculture is evil. There are clear benefits like increased yield, reduced water, fertilizer usage, etc.
What about the farmers?
As per the 2015-16 agriculture census, marginal and small farmers make up 86% of the total farmers in India and are the most vulnerable to extreme weather events.
Keeping aside the concerns of food security, these farmers are the biggest losers of the current agricultural system.
A safety net for these farmers seems to be missing.
Based on inputs from various interest groups, a robust crop insurance system might just do the trick. The only problem is that the current crop insurance in India has not worked really well, and there is a huge scope for improvement.
Chart of the week: How climate change may force farmers to change what they grow.
Source: The Economist
Related reads:
Global Climate Change Impact on Crops Expected Within 10 Years, NASA Study Finds
— Written by Abhinav
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