Trading Psychology – Herd Mentality

Herd MentalityHerd Mentality results in the dilution of I.Q. by the members of a group.  This dilution increases exponentially with the size of the group and the level of emotion common amongst members.  Herd Mentality is the reason why a group of people can abandon reason and descend into madness in a way that any individual of the group would not, it is also a major cause of Contagion.  For this reason it is essential to maintain your individuality when investing.  In doing so you can objectively observe the herd’s behavior and profit from its stupidity.

Herd mentality is not reserved for the stock market; have you ever watched a riot on TV and seen regular people committing terrible acts of violence with a complete disregard for others?  This is a reaction to peer pressure which makes individuals act in order to avoid feeling ‘left out’ from the group.

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Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one! – Charles Mackay

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French sociologist Gustave Le Bon developed a theory called Contagion (different from Financial Contagion).  It assumes that crowds exert a hypnotic influence over their members.  People find themselves in a situation where they are anonymous and can abandon personal responsibility.  They get sucked up in the contagious emotions of the crowd and can be driven toward irrational, often violent action that most isolated individuals would not attempt.[1] The main flaw in this theory is that crowd behavior is not necessarily irrational.

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The crowd is always intellectually inferior to the isolated individual, but that, from the point of view of feelings and of the acts these feelings provoke, the crowd may, according to circumstances, be better or worse than the individual.  All depends on the nature of the suggestion to which the crowd is exposed – Gustave Le Bon

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Another theory to explain Herd Mentality is called Convergence.  It suggests that crowd behavior is a product of the convergence of like-minded individuals; that people who wish to act in a certain way come together to form crowds.[2] Floyd Allport, a man considered the founder of social psychology said “The individual in the crowd behaves exactly as he would behave alone, only more so.”  Convergence theory better explains why not all groups of people behave irrationally but does not explain why some people do things in a crowd that they would not have the courage to do alone.

I agree with both theories in part.  My research suggests that it is the underlying emotions of the crowd that hold the key to understanding its behavior.  If the emotions are negative such as anger, hate, fear, greed etc. then the resulting behavior is best explained by Contagion Theory.  As the negativity and the intensity of the emotions increases the resulting behavior is progressively more animalistic and irrational.

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Examples:

  • The Netherlands Tulip mania 1636–37
  • New York Draft Riots 1863
  • The Roaring Twenties and the crash of 1929
  • The Black Monday market crash October 1987
  • June 2001 riot by Los Angeles Lakers fans after the Lakers victory over Philadelphia in the NBA Finals
  • Run on the Bank of England September 2007

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Stock market bubbles and crashes are great examples of Herd Mentality and Contagion Theory.  They tend to begin and end with extremes of emotion; frenzied buying (Greed) to cause a bubble and then selling in a panic (Fear) to trigger a crash.  Otherwise sensible people act against their better judgment.[3] Individuals don’t want to be ‘left out’ and rush with the crowd into or out of the market.

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The crimes of Nazism are not the crimes of one nation.  Cruelty a taste for violence, the religion of force, ferocious racialism, are not the prerogative of a period or of a people.  They are of all ages and of all countries.  They have biological and psychological bases which it is by no means certain that we shall escape again.  The human being is a dangerous wild animal.  In normal periods his evil instincts remain in the background, held in check by the conventions, laws and criteria of civilization, but let a regime come that not only liberates these terrible impulses but makes a virtue of them, then from the depths of time the snout of the beast reappears, tears aside the slender disguise imposed by civilisation and howls the death-cries of forgotten ages – Jacques Delarue (The History of the Gestapo)

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However if the underlying emotions are positive such as love, peace, serenity, unity, understanding etc. then the resulting Herd Mentality is better explained by Convergence Theory.

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Examples:

  • The majority of weekly Religious Gatherings
  • The majority of sporting events
  • The majority of music concerts
  • Peaceful Protests

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The most significant example of Herd Mentality as explained by Convergence Theory was seen during the Salt Satyagraha.  It was a campaign of non-violent protest against the British salt tax in India lead by Mahatma Gandhi.  There are reports of over 100,000 people at times marching in a spirit of peace, unity and harmony.[4] These people were suffering racial and financial injustice and had every reason to be angry yet they remained non-violent.

So what has this got to do with making money in the stock market?  Well, it’s the emotions of fear and greed that cause the Wall Street herd to behave irrationally.  In contrast; Gandhi, through maintaining positive emotions and resisting anger and fear, induced 200 million people to maintain their composure and act with a clear mind.  The result was to bring Britain, a world super power to its knees without any violence or financial backing.

To stay separate from the herd we must remain emotionally neutral, resisting both fear and greed.  This is only possible when you know that probability is in your favor.  Then you don’t need to care about the outcome of a particular trade, you can remain detached from the outcome and let the law of averages run it course.

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If you cannot control your emotions you cannot control your money – Warren Buffett

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A fascinating aspect of Trading Psychology is that when the emotional influence on members of a group is low, Herd Mentality evolves into Group Intelligence.

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Even the intelligent investor is likely to need considerable willpower to keep from following the crowd. – Benjamin Graham

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What tactics do you use to remove emotions from your investing decisions?  Have you ever been caught following the crowd?

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Part 1 – Trading Psychology

Part 3 – Group Intelligence

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  1. ^ The Crowd: A Study of the Popular Mind, 1896 by Gustave Le Bon.
  2. ^ Sociology, 2007 by John J. Macionis.
  3. ^ Herd mentality rules in financial crisis by Maggie Fox, Reuters September 30, 2008.
  4. ^ Gandhi and Salt Satyagraha, 1981 by S. R Bakshi.

The World Economy Makes Contagion Go Round

Contagion is a concept that not many people are familiar with but it’s a very real, powerful and important force in our financial markets. We see contagion in effect every time a reaction in one market spreads into another. As Gordon Brown, ex-Chancellor and Prime Minister of Britain said:

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No matter where it starts, an economic crisis does not stop at the water’s edge.  It ripples across the world…  Modern communications instantly span every continent.  The new frontier is that there is no frontier, the new shared truth is that global problems need global solutions.[1]

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A vast amount of research into this interrelationship has been undertaken but still very little is really known about its causes.  Unfortunately much of the information available on the subject is in the form of complex academic papers.  In this article I attempt to briefly and simply cover what contagion is and what’s known about its major causes.

Definitions for contagion vary greatly and range from the broad:

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Contagion is the cross-country transmission of economic shocks.

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To more restrictive definitions:

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Contagion is the transmission of financial shocks from one country to another that can not be explained by any fundamental or rational link.

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My research suggests that contagion has many causes and find both definitions too restrictive.  Examples of this phenomenon can be seen in good times and bad.  Not just when shocking news is released such as a downward revision of GDP growth or a prolonged crisis like the credit crunch of 2008 (although situations like this do appear to amplify the effect).

Because contagion occurs in both bull and bear markets and has many different causes, I have given it the following very broad definition:

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Contagion is the cross-country correlation of financial markets due to one or a combination of factors including: Margin Calls, International Counterparty Risk, Fundamental Links, Cross-Market Hedging and Herd Mentality.

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Exactly which cause is responsible for contagion in each situation is difficult to prove but evidence suggests that it usually results from a combination of factors.  I will cover the top five factors followed by a case study and summary of my research:

  1. Margin Calls
  2. International Counterparty Risk
  3. Fundamental Links
  4. Cross-Market Hedging
  5. Herd Mentality

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1. Margin Calls

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Margin calls can lead to contagion when two economies are connected by investors with holdings in both.  News that leads to a drop in asset prices in Country ‘A’ can trigger margin calls that are met by the forced selling of assets held in Country ‘B’ even though Country ‘B’ may not be affected directly by the news.

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Panic selling by hedge funds has emerged as the hidden cause of the contagion spreading through the global financial system. – UK Telegraph[2]

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In August 2007 Goldman Sachs’ 9 billion[3] dollar hedge fund ‘Global Alpha’ saw its assets decline 22.5%.  Was this because of exposure to mortgage backed CDO’s like so many other hedge finds that were running onto trouble?  No, Global Alpha’s losses in that month came from positions in currencies like the Japanese Yen and the Australian Dollar as well as stocks holdings in the US, Norway and Finland.[4]

As the housing market went south the funds that were exposed to toxic CDO’s needed to raise cash to meet margin calls.  However redemption of these bad assets was almost impossible because the market for them had become illiquid and frozen.  In a panic they were forced to close out of positions they had in more liquid assets.  This caused declines in stocks around the globe and unusual behavior on the foreign exchange markets.[5]

At the time Global Alpha was leveraged 6 to 1 and when the market started to behave in a way that the funds computer models had not expected it started to experience significant losses.  This intern triggered more margin calls for Global Alpha forcing another cycle of selling on assets not directly affected by the original turmoil.[6] Here you can clearly see how margin calls can set off a domino effect of more margin calls which lead to contagion on unrelated assets around the globe.

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2. International Counterparty Risk

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If an institution in one country has obligations through the likes of debt, derivatives, or insurance in another country then its demise will have a global impact.  No example of this is more profound than that of troubled insurance giant AIG.  In early 2009 they held roughly 74 million insurance polices, issued in more then 130 countries.[7] The notional value of their derivatives portfolio was approximately 1.6 trillion covering a counterparty base of over 1,500 clients.  These clients included top banks, wealth finds, major corporations, governments and institutional investors.[8]

Due to its integral position in the functioning of the global financial system Sen. Christopher Dodd, chairman of the Senate Banking Committee described AIG as having the “world financial system by the throat”.[9] The US Federal Reserve Chairman, Ben Bernanke deemed them “too big to fail”, saying such large, interconnected financial firms pose a “systemic risk” to economic stability.[10]

The failure of a company like AIG would cause turmoil in the U.S. economy and global markets, and have multiple and potentially catastrophic unforeseen consequences.  This is a prime example of how counterparty risk can cause contagion in financial networks.

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Fundamental links are the most obvious and easy to understand causes of contagion.  These links are usually the result of international trade where two countries trade with each other or compete in the same foreign market.  A drop in the currency valuation of Country ‘A’ will eat into the competitive advantage of Country ‘B’, the likely consequence being that both Country ‘A’ and ‘B’ will end up devaluing their currencies to re-balance their external sectors.[11]

Some fundamental changes have a global impact, such as fluctuations in the price of oil.  Others financial links are the result of a direct investment by one country in another.  In December 2009 China held $755.4 Billion dollars of US Treasury Securities which was 21% of the total outstanding.[12] In 2009 The US also did $365.98 billion[13] in trade with China of which $266.8 billion was a deficit.[14] It is clear to see how the US and China are fundamentally joined at the hip and how this will lead to contagion between the two.

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4. Cross-Market Hedging*

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Many global investment managers aim to keep their portfolios optimally hedged at all times.  When a change is required due to the release of new information about macroeconomic risk factors or simply a change in asset prices this will alter the global balance of their portfolio.  The required re-balancing transmits the effect from the source market to the other markets in their portfolio causing a correlation or contagion over the short term.[15]

*I have used the term hedging instead of rebalancing (as used in “A Rational Expectations Model of Financial Contagion”[15]) because rebalancing can occur for several reasons, only one of which is cross-market hedging.

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5. Herd Mentality

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Herd Mentality is the result of a reaction to peer pressure which makes individuals act in order to avoid feeling ‘left out’ from the group.

French sociologist Gustave Le Bon developed ‘Contagion Theory’ (different from Financial Contagion).  It assumes that crowds exert a hypnotic influence over their members.  People find themselves in a situation where they are anonymous and can abandon personal responsibility.  They get sucked up in the contagious emotions of the crowd and can be driven toward irrational, often violent, action that most isolated individuals would not attempt.[16] However the main flaw of this theory is that crowd behavior is not necessarily irrational.

On the investment landscape people are notorious for acting in herds and those investing abroad are often the worst offenders.  It is very hard for an investor to understand all of the economic factors in their home market let alone a foreign one.  Rather than basing their decisions on fact, many will allow their decisions to be affected by the action they witness in the surrounding markets, regardless of any fundamental link.

For instance Indonesia was the worst affected economy in the Asian crisis, which is surprising because they had comparatively sound macroeconomic fundamentals.  They had the highest economic growth in Southeast Asia, low inflation, a modest current account deficit, rapid export growth and growing international currency reserves.

Fundamentals alone do not explain the severity of the Indonesian problems in 1997.  Indications are that contagion of the more real crisis occurring in Thailand caused the crisis to spread to Indonesia.  What was happening in Thailand lead international investors to reassess Indonesia’s economic performance.  Rather than base their decisions on real links, people just followed the Herd.  This facilitated the contagion effect by fueling a spread of fear from Thailand to Indonesia leading to illogical declines in asset values.[17]

Herd Mentality helps to amplify and perpetuate other causes of contagion as well.  Good news that has a rational fundamental link between Countries ‘A’ and ‘B’ can be over compensated for due to the spread of greed throughout the Herd; no one wants to miss out on the rally.  This greed can then spread through the Herd to Countries ‘X, Y and Z’ that lack a fundamental link to the original good news.  Fear appears to spread around the globe much more effectively than greed however, and the resulting ‘death spiral’ can be difficult to stop.  This is all typical of Herd Mentality; it helps spread panic and irrational exuberance around the globe.

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The five causes I have mentioned appear to be the main causes of Financial contagion and each can be observed in many instances as having a measurable impact.  However it is unlikely that we will ever been able to measure the relative importance of each cause and it appears as though the role each plays varies from case to case.

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Case Study

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A prime historical example of contagion can be seen by the effect that the Russian bond default had on Brazil.  But how much of the reaction toward Brazil after the 1998 crisis in Russia was due to margin calls and how much was due to the Herd Mentality facilitating the spread of panic?

Despite support from the International Monetary Fund, in August 1998 Russia defaulted on its sovereign debt, devalued the ruble, and declared a suspension of payments by commercial banks to foreign creditors.[18] During this crisis the asset prices in Russia, Brazil, and the US despite having little fundamental relationship to each other, exhibited the following common patterns:[19]

  • Market depth and liquidity decreased simultaneously.
  • The volatility of prices increased simultaneously.
  • The correlation of prices on seemingly independent positions increased.

For reasons no one appears to be able to agree on, the Russian devaluation prompted a capital flight from Brazil and eventually a significant loss in value of its currency.[20] The concept of contagion was on vivid display in perhaps its most logic-defying form.  For some reason the spreads on Russian and Brazilian Brady Bonds and reserves during this period became remarkably correlated.[21]

The Russian contagion to Brazil crossed international borders to a country with a very different economy.  Countries with fundamentals closely matching Russia’s did not experience a financial crisis so why would the events in Russia affect Brazil so profoundly?  Brazil’s economy was much bigger than Russia’s[22] and was more likely to benefit from low-oil prices than to suffer as Russia had.  Nevertheless, the implosion of the Russian economy caused massive financial problems in Brazil.

There has never been such a pronounced example of market contagion where the markets that are less fundamentally related.  Was this due to fear, margin calls, cross-market hedging or something else?  It is hard to say but no one can deny that contagion occurred in a way that is impossible to quantify with the current model for economic logic.

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Summary

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The power of contagion has been growing steadily for the last 20 years thanks to globalization and the growing speed and availability of information.  Today, in the Information Age we live in a smaller, more integrated world and we look set to continue to move towards a truly global economy.  Already we have the ability to work as a unit in real time.  Communication, trade, employment, personal and commercial transactions are now occurring on a global scale.  Largely, international and regional boundaries are being ignored;[23] capital now flows far more freely between countries.[24]

In some ways this globalization helps to stabilize things and prevent another world war.  To go to war with countries that you depend on for trade and are so heavily invested in would be economic suicide.  In other ways it means that when a recession occurs there are few areas that are not effected making it very hard to find a safe haven for your capital.[25]

All of this leads to more contagion; it is real and will continue to have an impact on the financial landscape for a long time to come.

Have you seen the effects of contagion on your finances?  What do you think the causes were?  Please share your thoughts in the comments section below.

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  1. ^ New global deal needed to tackle recession, says Brown, Isish Times, March 5, 2009 by Denis Staunton
  2. ^ Hedge fund panic was behind global stock markets collapse, UK Telegraph, August 11 2007 by Helen Power and Dan Roberts
  3. ^ Did Genius Fail Again at Goldman Sachs’ Global Alpha Fund?, Seeking Alpha August 14, 2007 by Michael Shedlock
  4. ^ Goldman’s Global Alpha Fund Fell 22 Percent in August (Update3), Bloomberg, September 13, 2007 by Jenny Strasburg and Katherine Burton.
  5. ^ Quant Bloodbath Revisited, Lehman Brothers Stategist Becomes The Sage of The Subprime Contagion Theory, Deal Breaker, August 13, 2007 by John Carney.
  6. ^ Blowing up the Lab on Wall Street, Time – Business & Tech, Thursday, Aug. 16, 2007 by Richard Bookstaber, Paragraph 6
  7. ^ US takes another crack at AIG rescue, March 3, 2009 CNN Money
  8. ^ AIG: Is the Risk Systemic? Draft, March 6, 2009 Prepared by American International Group, Inc.
  9. ^ ‘Too big to fail’? More like ‘too unknown and scary to fail’, March 15, 2009 Los Angeles Times
  10. ^ Bernanke: Fix banks to get a recovery, CNN Money, March 10, 2009
  11. ^ An Evaluation of the Devaluation by Sam Vaknin, Ph.D.
  12. ^ Major Foreign Holders Of Treasury Securities, December 2009
  13. ^ Top Ten Countries with which the U.S. Trades, December 2009
  14. ^ Top Ten Countries with which the U.S. has a Trade Deficit, December 2009
  15. ^ A Rational Expectations Model of Financial Contagion, April 19, 2001 by Laura E. Kodres and Matthew Pritsker. Part III Contagion Through Cross-Market Rebalancing, Pages 15-23
  16. ^ The Crowd: A Study of the Popular Mind, 1896 by Gustave Le Bon
  17. ^ Indonesia’s Economic Crisis: Contagion And Fundamentals. The Developing Economies Volume 40 Issue 2, Pages 135 – 151 March 6, 2007 by Reiny Iriana And Fredrik Sjöholm
  18. ^ Russia and Brazil: Two defenseless giants, January 19, 1999 by Sergei Blagov
  19. ^ Contagion as a Wealth Effect by Kyle, Albert S. and Wei Xiong, 2001. Journal of Finance, Vol 56, Iss. 4, pages 1401-1440
  20. ^ Brazil crisis underlines the need for new solutions by Martin Khor
  21. ^ The Russian Default And The Contagion To Brazil, 2000 by Taimur Baig And Ilan Goldfajn. Page 8, Figure 1
  22. ^ Chapter 1 Current State of the World Economy, Section 1: Overview of the World Economy, Table 1-1-1
  23. ^ Speech at Credit Suisse First Boston Asian Investment Conference, March 26, 1999. International Capital Flows and Free Markets by Joseph Yam, JP Chief Executive Hong Kong Monetary Authority. Conclusion
  24. ^ The Economics of Developing Nations and the Global Financial Crisis, Thought Economics – Business & Strategy for “Economy 2.0” 15 December 2008 by Vikas Shah. Paragraph 1
  25. ^ A recession of global dimensions? – Globalization is a wonderful thing for the U.S. economy. It’s also driving the dramatic slowdown that’s underway. January 22, 2008 by Geoff Colvin