Monday, February 14, 2011

The Wisdom of the Herd

The Economist recently reviewed the IMF's report on their own failings to foresee the financial crisis. At one level it's quite depressing, but at another it's (almost) reassuring. The IMF's findings will be only too familiar to an Irish audience:
Staff reported that incentives were geared toward conforming with prevailing IMF views. Several senior staff members felt that expressing strong contrarian views could “ruin one’s career.” Thus, views tended to “gravitate toward the middle” and “our advice becomes procyclical.” Staff saw that conforming assessments were not penalized, even if proven faulty.

...Self-censorship appeared to be a significant factor even in the absence of overt political pressure. Many staff members believed that there were limits as to how critical they could be regarding the policies of the largest shareholders—that “you cannot speak truth to authorities” since “…you’re owned by these governments.
Michael Lewis' article for Vanity Fair paints a similar picture of how dissenting voices in Ireland were treated prior to the collapse. The IMF's findings confirm that economic myopia is not confined to Ireland however.

So what is to be done? Ultimately we must face the reality of human behaviour. We are motivated by social norms to behave like everybody else. It's Lesson 4 in Sapra and Zak's guide to the eight lessons of neuro-economics for money managers (ht Simoleon Sense):
What was beneficial for our ancestors on the African savannah does not always serve us well in financial markets. Social learning is great when mastering calculus or riding a bicycle, but herd behavior in markets is typically detrimental. Herd behavior violates the “all else being equal” rule in economics in that investor decisions are not independent, and mispricing is thus likely to occur. Trading does not occur in a vacuum; often traders buy an asset because they see it going up in value. As more investors jump on the bandwagon, herd mentality results in a price bubble.

Our brains have evolved to make us desperately want to follow the crowd. Riots, overly popular restaurants, and asset market bubbles are the results. Herd behavior can occur even when individuals do not coordinate with each other but trade only on the basis of private information and prices.
...But evaluating alternatives while others follow trends goes against our nature because our brains bias us to follow the crowd. Desperate buying and panic selling are the inevitable consequences of herd mentality. Instead, investment professionals should discount their evolved bias toward following others and be contrarian. This approach will make them feel alone and exposed—two things our ancestors feared the most.
 No wonder those shouting 'stop' have such a hard time when the everyone else is shouting 'go'.  One of the great challenges we face in Ireland is that of creating a culture that is less conducive to herd thinking. Regulatory and organisational reform will not be enough. We only have to look at the IMF to see that.

5 comments:

  1. An outstanding summary that puts its finger on some of the most important factors that led to this crisis. As to what should be done to prevent herd behaviour? What indeed! For a start, interview boards could stop asking the standard "are you a good team player?" question of prospective employees. We all know the correct answer, but which great leader or innovator was ever a bloody good team player? It's just another way of describing a drone. Wake up Ireland, you're on the very edge!

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  2. Is this science or conjecture? What would a culture 'less conducive to herd thinking' look like and how would one create such a thing?

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  3. @Hugh
    @Penal-Colony

    I think the problem of herd thinking will always be with us. We're hard-wired that way. But it is possible through whistle-blower and transparency policies to at least provide some channels for 'contrarians' to have their say.

    A free press helps as well, though a de-centralised one probably helps even better. Luckily we appear to be going that way thanks to the web etc.

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  4. Also, Oversight Committees attached to Government Departments, say, whose sole purpose it is to hold those departments accountable to rigorous codes of ethics, the law and the people.

    I was fired from my last job for being a whistle-blower, ie, for not being a 'team-player'. It's not all it's cracked up to be. It doesn't put food on the table.

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  5. It's all very well drafting 'whistle-blower' legislation and then sitting back and waiting for someone lower down the chain of command to be the ethics watchdog for the company or quango. In other words, as Penal-Colony rightly says, the subordinate employee risks a great deal to maintain the standards which his superiors should be applying as a matter of course. Instead of leaving it to brave employees, it might be more useful to extend the criminal law so that a company and its directors (or a government department, its minister and senior civil servants) can be held personally liable for crimes or misdemeanours that occurred on their watch. This is already the case with the crime of Corporate Manslaughter, for instance, that saw Network Rail in the UK being held responsible for some of the rail disasters that have taken place there. If owners, directors, or ministers knew they could end up in jail or see their companies collapse because of their negligence or greed, I doubt we would need 'whistle-blower' legislation at all.

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