You've heard that one way to succeed in investing is not to follow the herd. However, recent experiments by professors at the Universities of Oxford and Wales Bangor show that it may be natural for people to herd just like animals when they are in a crowd, as reported by The Telegraph (2/14/08) The scientists told volunteers to start walking around a large hall with no particular destination. Then they gave a few of the volunteers some directions on where to walk. It turns out that it took only 5% who seemed to be informed to sway the rest of the crowd of 200 people or more. "There are strong parallels with animal grouping behaviour," says Professor Jens Krause, who led the team of scientists.
Bob Prechter has written extensively on herding behavior in human beings and the financial markets, tied in with his theory of socionomics, which is the study of how humans behave in groups within contexts of uncertainty. In this excerpt from an interview with Market Technicians Association, Bob explains his views on finance vs. economics, herding, and social mood.
* * * * *
Excerpted from an interview conducted on October 5, 2007, and first published by the Market Technicians Association; reprinted in The Elliott Wave Theorist, January 2008
Q.: How does socionomics fit into [your forecast of a long, deep price collapse in the financial markets]?
Bob Prechter: Among many other things, socionomics explains why the market reaches valuations that later generations describe as absurdly low or absurdly high, like today.
Q.: But that’s not so unusual.
Bob Prechter: That’s exactly the point. It’s normal for financial markets to careen wildly from overvaluation to undervaluation. But can you recall this kind of thing happening in markets for sandwiches or lawnmowers? … In the marketplace for goods and services, you use your reasoning power to decide whether a purchase is a good use of your money. This is called “maximizing the utility of your resources.” When steak gets too pricey, you buy chicken, and vice versa. When there’s a sale on, you rush out to buy more. But—and this is crucial—when prices go down in the stock market—in other words, when there’s a sale—almost everyone wants to own fewer shares. And when prices go up, investors buy more. See the difference? Theoreticians either ignore this fact or call buying high and selling low a “temporary anomaly,” but it is the rule in financial markets. And it’s the opposite of the rule that holds in economic markets. This is a fundamental difference between the two.
Q.: O.K., so that’s why your paper [published in The Journal of Behavioral Finance] is titled “The Financial/Economic Dichotomy.”
Bob Prechter: Right. And in the world of financial theory, this is a radical idea. For half a century the reigning model, called the Efficient Market Hypothesis, has said that financial markets are just like economic markets: People take all information into account and buy or sell according to what’s reasonable. But if they did that, they would buy more when prices were low and less when prices were high, wouldn’t they? But they don’t.
Q.: Is that the only thing wrong with the old theory?
Bob Prechter: Oh, no. It’s full of errors. Economic theory says that prices seek equilibrium. It says they are random. It says they are objectively determined. It says they are completely unpredictable. None of this is true. So the old theory is broken. We need a new theory.
Q.: Which is…?
Bob Prechter: My colleague Wayne Parker and I call it the socionomic theory of finance, or STF. Under our model, prices are dynamic, not stable; they are subjectively, not objectively, determined; they are not random but patterned; they do not seek equilibrium but instead conform to the Wave Principle; and they are probabilistically predictable because herding is patterned.
Q.: That’s a lot of differences. And what’s this about the law of supply and demand not pertaining? That sounds really radical.
Bob Prechter: No kidding. But the law of supply and demand is irrelevant to financial markets. There are no producers and consumers in financial markets, just investors. So there are no balancing forces on price. The law of supply and demand reigns at the shopping mall because consumers are pretty certain of their needs and resources, so they can reason their way through the decision process. But investors are uncertain because they have no basis to decide a fair price. In the financial context, knowing what you think is not enough; you have to try to guess what everyone else will think. It’s not easy to use reason to figure that out. When everyone faces this dilemma, the result is herding. Herding is an unconscious impulsion, not a reasoned response to prices and values. So financial markets follow a different law. We say that economic prices conform to the law of supply and demand but financial prices conform to a law of patterned herding.
Q.: Then what makes prices fluctuate?
Bob Prechter: The herd has little basis to judge what others will think about values in the future, so the main determinant of aggregate prices is the mood of the crowd, the social mood, whether it is optimistic or pessimistic, hopeful or fearful. Social mood has a fractal structure, little waves inside bigger waves, which accounts for the fluctuations in the market of all different sizes.