Business

Watch out, herding comes naturally to us

Watchword is caution:  Herding, which leads to high volatility in returns, can be profitable if you can capture short-term price increase in exchange-traded assets. .

Watchword is caution: Herding, which leads to high volatility in returns, can be profitable if you can capture short-term price increase in exchange-traded assets. .

Greed, for lack of a better word, is good, said Gordon Gekko, a character portrayed by Michael Douglas in the 1987 Hollywood classic, Wall Street .

But what about herding (crowd behaviour) that drives prices? In this article, we show why herding is good for trading, but not so for goal-based portfolios.

Your trading portfolio should capture short-term movements in the market. That means you ought to buy stocks that are on an uptrend, referred to as momentum trades; for, a stock that is on uptrend will continue to be on an uptrend till an opposite force acts on it.

There is a behavioural reason to support this phenomenon. The fear of missing out (FOMO) on a good investment is greater than the suffering one experiences from losses on a bad investment. It is often greed that prompts individuals to demand stocks that are already on an uptrend.

The increased demand for a stock pushes its price up further. That makes herding attractive. So, if you know how to read price patterns, then herding can be profitable. Note that herding also works for downward price movements.

But most prefer to take advantage of upside movement because shorting (selling a stock without owning it) is risky. Also, we are hard-wired optimists. So, going long (buying) is a natural process than going short on a stock. Riding the herd is only one part of the strategy. The other part is to know when to detach from the herd and take profits. This is important because stocks that are part of a herd behaviour are vulnerable to momentum crash. That is, these stocks can fall sharply, often independent of the direction of the broad market.

It is not optimal to herd for your goal-based portfolios.

When to avoid herding

Why? Your primary objective in goal-based investments is to accumulate the required wealth to achieve a goal. Suppose you are saving to make down payment for a house. A product that catches market fancy, say investing in farmland, may not fit with your goal. The argument is no different with mutual funds (example, an infrastructure fund) or other financial products including new-age investments such as cryptos and non-fungible tokens.

Another reason is that herding leads to high volatility in return. This can be attributed to a sharp increase in demand followed by a steep decline in market interest resulting in a U-turn in prices. Such volatility can hurt your goal-based portfolio. Suppose your equity portfolio earns unrealised gains of 50% from herding and then loses 50% from a momentum crash.

You would have in aggregate lost 25% (100 times 1.5 times 0.5) of your initial capital. Note that a goal-based portfolio must earn a minimum return to accumulate the required amount at the end of the term horizon for a life goal.

In this case, not only has your portfolio failed to achieve the minimum return but has also suffered losses. This is one of the reasons why you should prefer large-cap and broad-cap equity funds for your goal-based portfolios; for, large-cap stocks do not typically participate in momentum runs.

Conclusion

If herding is good for trading but not for goal-based portfolios, what about passion assets? These are your collectibles that double up as investment assets; for instance, antique furniture, arts, and rare artefacts.

Herding in this case would mean that many individuals are surprisingly interested in collecting, say, antique pottery. Given the limited supply, herding could drive up prices of such assets. Also, a sudden interest in antique pottery could lead to unscrupulous sellers passing off reproduction pottery as antiques. The above discussion suggests that herding can be profitable if you can capture short-term price increase in exchange-traded assets.

To herd is human because of FOMO. Also, herding reduces regret as we fail with the crowd. So, herd with caution.

(The writer offers training programmes for individuals to manage their personal investments)


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Printable version | May 29, 2022 8:08:19 am | https://www.thehindu.com/business/watch-out-herding-comes-naturally-to-us/article38275669.ece