Canadian Finance Blog

---

Staying Away from Herds Posted: 09 Dec 2010 02:00 AM PST The bond herd is today’s big herd. So is the gold herd. Members of these herds tell one another that stocks would always lose as they did in 2008. Yet smart investors stay away from herds, whether bulls or bears. Instead, smart investors maintain diversified portfolios of bonds, stocks, and other asset classes. The story of Bernard Madoff is a cautionary story of herds. In late 2008 Madoff confessed that his investment company was nothing but a Ponzi scheme, where longtime members of a herd of investors were paid from the money deposited by new members. Madoff was sentenced to 150 years in prison, but his investors were calling on God to punish him some more. "May God spare you no mercy," cried Tom FitzMaurice, a sixty-three-year old defrauded Madoff investor. How can investors stay away from herds when friends and neighbours join them? Good judgment of information is one part of the answer. Good assessment of the consequences of a wrong choice is another. The consequences of choosing the wrong restaurant by joining the herd at its entrance are small, while the consequences of choosing the wrong investments are large. But how could have Madoff's investors obtain information about Madoff's operations when Madoff guarded his information so closely and distorted it? In truth, Madoff's investors had the information they needed to avoid his scheme but failed to apply good judgment to it. One part of their information was in the maxim "If it sounds too good to be true, it probably is." The complementing part was Madoff's reported returns, combining high returns with low risk. My mother would tell the fable of a village woman who borrowed a spoon from a neighbour, returning it the following morning along with a teaspoon. "The spoon gave birth to the teaspoon last night," she explained. Next she borrowed a cart, only to announce the following morning that the cart had died. People who are gullible enough to believe that spoons give birth should not be surprised when carts die. Madoff's returns were too good to be true. Investors who follow the too-good-to-be true maxim might regret it from time to time. After all, opportunities to invest in fabulous hedge funds that promise great returns and deliver them are not as impossible as spoons giving birth to teaspoons. But investors who follow the maxim are not likely to fall for Madoff-like schemes. Next, Madoff's investors could have reflected on the credence of the information in the hands of members of the herd. Compare Madoff's investors to shoppers of washing machines consulting a Consumer Reports survey. Consumer Reports' information is the information of the washing-machine herd, based on Consumer Reports' own laboratory analysis of many machines and questionnaires completed by thousands of users. We are smart to set aside our information and follow the Consumer Reports' herd, not only because its tests are rigorous, but also because its reports are unbiased. Consumer Reports is not tempted to skew its reports toward companies that advertise in it because it accepts no advertisements. Moreover, Consumer Reports has the incentives to provide unbiased reports; its revenues depend entirely on subscriptions and donations of readers who expect unbiased reports. It surely does not follow the practice of Wall Street–rating agencies that accept payments from companies whose securities they rate. Compare Madoff's prospective investors to Consumer Reports readers. Madoff's prospective investors had little information of their own about Madoff's investments, but they should have known that the reliability of the information in the hands of current Madoff's investors was far from that of current readers of Consumer Reports. Moreover, incentives were not set in favour of Madoff's prospective investors. It turned out, too late for Madoff's investors, that some prospective investors did investigate Madoff's investments and concluded that his reported returns could not possibly be true. These prospective investors chose not to invest, but there was no feasible way for them to profit from their analysis by selling Madoff's shares, since Madoff's company was a private company whose shares were not traded on the stock exchange. There was also no feasible way for them to profit by selling their information to current Madoff's investors who could have benefited from it. Harry Markopolos, one of these prospective investors, tried to convey his Madoff information to the Securities and Exchange Commission. The Commission did have an incentive to uncover Madoff's fraud but was overwhelmed and perhaps incompetent. Herds are always enticing, and many investors are always switching from one to another. Yet herds tend to run in the wrong direction more often than they run in the right one. Today’s big herds are the bond and gold herds. Tomorrow’s big herds might be the stock and real-estate herds. Yet investors are wise to hold on to diversified portfolios and stay away from herds. Author Bio: Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University and Visiting Professor at Tilburg University in the Netherlands. His research focuses on behavioral finance. He attempts to understand how investors and managers make financial decisions and how these decisions are reflected in financial markets. Meir’s book, “What Investors Really Want,” has just been published by McGraw-Hill. Related Posts: Experian Closes Their Canadian Consumer Credit Bureau A Look At Ponzi Schemes In Canada Check Your Credit Reports Staying Away from Herds originally appeared on Canadian Finance Blog on December 9, 2010.

You are subscribed to email updates from Canadian Finance Blog To stop receiving these emails, you may unsubscribe now.	Email delivery powered by Google
Google Inc., 20 West Kinzie, Chicago IL USA 60610