In a typically erudite note on Wednesday, SocGen’s Dylan Grice declared his allegiance to the anti-groupthink brigade, warning of the deleterious effect of the herd mentality on returns.
As he put it:
A trader I once knew used to say that when it came to taking risk, if it felt right it was probably wrong. Herding is a good example. It feels right because the act of ‘conforming’ activates the brain’s reward system, releasing dopamine. But it’s nearly always wrong. The sell-side are as hardwired to herding as anyone else. The sectors most loved by them underperform those which are most neglected by them.
Grice’s trader friend might not have known it, but neuroscience supports his intuition that going against the herd “feels wrong“. As the SocGen strategist explained (emphasis ours):
Earlier this year, and quite disconcertingly, neuroscientists in the Netherlands led by Vasily Klucharev demonstrated that the neural mechanism which allows us to learn is the very same neural mechanism which causes us to herd!
We learn by making ‘predictions’ and comparing outcomes to those predictions. When the predictions are correct the reward system of the brain is activated and dopamine is released by the nucleus accumbens (the brain’s ‘pleasure zone’). But when the predictions are incorrect, a ‘prediction error signal’ deactivates the pleasure zone. This process of reward and punishment guides the continuous evaluation of our environment and steers us towards the gradual accumulation of knowledge.
But what Klucharev showed was that, when we don’t conform to the group, our brains flash the same “prediction error signal” we receive when we’ve failed to judge an outcome correctly. When it comes to developing our ability to think outside the crowd, we’re effectively hardwired with learning difficulties.
Now consider the charts below, which Grice used to illustrate his theory that “sector herding” — the extent to which a stock was covered, measured by the number of analysts looking at it — might be a one way of finding contrarian investment opportunities:
BAAH stands for the “Bank’s Aggregate Analyst Herding” index – and is also, and not coincidentally, an onomatopoeia for the noise of bleating sheep.
As the second chart shows, the most crowded sectors are clothing and construction, while energy and tobacco are the least. According to Grice’s back testing (emphasis FT Alphaville’s):
It turns out that a long-short strategy of buying the sectors where herding is less dominant and shorting those where coverage is deepest would have generated around 7% p.a. since 1987. The cumulative results of the strategy are shown in the chart below. For a given market cap, it seems, the more analysts you see swarming around a sector the more wary you should be of being able to extract alpha from it. Leave the herd to its dopamine fix and have another think about the less-crowded sectors.
And for any interested, here are two of the readings Grice cited in his note:
- ‘Reinforcement Learning Signal predicts Social Conformity’, Vasily Klucharev et al (2009)
- Wisdom of Crowds: Why the Many Are Smarter Than the Few, by James Surowiecki (2004)
Related links:
Spunky contrarian analysis – FT Alphaville
SocGen questions contrarian credit calls – FT Alphaville
Contrarians are cool. Or not. – FT Alphaville
Securitisation and subprime mortgages – a contrarian view – FT Alphaville