What do the mating practices of female guppies have to with investing?
“As it turns out, female guppies have a genetic preference for bright orange males. But when [biologist Lee] Dugatkin arranged for some females to observe other females choosing dull-colored males, the observing females also selected the dull males.”
That was Michael Mauboussin’s way of introducing us to the power of imitation in both investing and guppy life. Like guppies, humans depend on imitation to guide them through many situations, including ones that require complex decision-making.
The role of imitation, and how it affects our investment decisions, is the subject of chapter thirteen of Mauboussin's book, "More Than You Know: Finding Financial Wisdom in Unconventional Places."
Feedback
The author introduces the idea of feedback, both negative and positive, and points out that well-functioning financial markets depend on a healthy balance between negative and positive feedback - negative because it is a stabilizing force and positive because it promotes change.
An example of negative feedback is the practice of arbitrage. When there is a gap between the price of a security and its intrinsic value, arbitrageurs buy or sell until the gap is closed or nearly closed, taking advantage of the difference to make a profit. In these cases, negative feedback is resisting change by pushing prices in the opposite direction to where they had been headed.
Positive feedback may be illustrated by referencing momentum investing, in which investors assume a stock price will keep going up. As long as enough investors believe in them, higher prices will become a self-fulfilling promise. This kind of positive feedback can lead to booms and busts.
Still, as Mauboussin observed, there is often a rational basis for positive feedback, based on the following factors:
- Asymmetric information - If you know another investor has better information about an investment than you have, then it makes sense to imitate.
- Agency costs - In this case, the author refers to money-management firms that must make trade-offs between making money for the firm and maximizing the portfolios of their clients. He wrote, “Companies that choose to maximize the value of the business have an incentive to do what everybody else is doing. This imitation minimizes tracking error versus a benchmark.”
- Preference for conformity - It is inherently human to enjoy being part of the crowd because the crowd can often offer safety and reassurance.
However, too much positive feedback will become a problem. That led Mauboussin into a discussion of “herding,” which happens when many investors ignore their own observations and instead follow someone else’s ideas.
Both positive and negative feedback demonstrate imitation. Whether buying or selling, investors are imitating when responding to feedback.
Thus, we might ask ourselves, how much imitation is too much? According to Mauboussin:
“Determining exactly how much positive feedback is too much may be an impossible task. Extensive scientific studies of innovation and idea diffusion reveal that there is typically a critical threshold, a tipping point, beyond which positive feedback takes over and the trend dominates the system. The relative frequency of bubbles and crashes strongly suggests that there are consistent discrepancies between price and value.”
For the legendary investor George Soros (Trades, Portfolio) and his theory of reflexivity, positive feedback exists between a company’s stock price and its fundamentals. He made his fortune by taking advantage of positive or negative feedback trends.
Other herding examples include:
- Mutual funds - Research by Russ Wermers showed a herding effect among mutual funds, primarily in small-cap and growth funds. Stocks bought by the herd outperformed stocks sold by the herd by 4% in the following six months.
- Analysts - They often check out what their peers are doing before making recommendations.
- Fat tails - Researchers have been able to replicate the fat-tail distributions that exist in markets. Mauboussin reported that their models provided a more “convincing picture” of market reality than those based on the models of rational investors.
According to Mauboussin, there is a symbiotic relationship between positive and negative feedback in the markets. As we’ve seen, momentum investing is a form of positive imitation and arbitrage is an example of negative imitation. He added that investors may deviate from their fundamental investment approach because of imitation, and that, in turn, will provide insights into the way we understand risk.
“Next time you buy or sell a stock, think of the guppies,” was his chapter-concluding advice.
Conclusion
Michael Mauboussin titled this as a chapter about imitation, yet it really is a series of psychological riffs on the theme of imitation. It also included lengthy sections on positive and negative feedback as well as herding.
As value investors, we might take this chapter as another warning against the seemingly quick and easy road to riches. At the end of 2019, it might be tempting to follow the momentum investors who are making money by herding with the crowd. Yet, we’ve seen momentum investors burned badly before as the market quickly turned down and they were left holding their overvalued stocks.
At the same time, it is a reminder that we could also follow a more select herd, such as the great investing gurus and our fellow value investors.
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