Why do people act like a herd around risky investments, causing “bubbles” that inevitably burst and leave most investors losers in the game? Couldn’t the players in the dot.com bust, for example, have seen disaster looming on the horizon? Why did more investors not get out earlier, and why did they continue to pump money into already over-inflated stocks? Similar questions surround the recent bust in the subprime mortgage market.
Two Stanford researchers say that what investors fear the most is not the risk of a loss per se, but the risk that they may do poorly relative to their peers. That means even though investments in areas such as new technology may be particularly risky, investors tend to cluster around such pie-in-the-sky opportunities to avoid being the only one in the neighborhood to miss out on the “next big thing.”
In three related theoretical studies, Peter DeMarzo and Ilan Kremer, along with Ron Kaniel of Duke University, have discerned that individual investors care deeply about how their level of wealth compares to that of others in their peer group and community. “Investors fear being poor when everyone around them is rich,” says DeMarzo, Mizuho Financial Group Professor of Finance at the GSB.
A primary reason for people’s concern, they explain, is that the cost of living in any community may depend on the wealth of its residents. The more money people have, the more expensive houses, real estate, daycare, and other necessities and amenities will be. “It’s worse to have a lower income in an area where everyone is wealthy than it is in an area where everyone has a similar income as you,” says Kremer, GSB associate professor of finance.
Using economic models, the researchers have discovered that such external worries have implications for how people invest. Specifically, they motivate people to choose portfolios that look a lot like those of others in their community or professional cohorts. “Such herding around certain investments allows you to combat the fear that everyone else might be betting on the winner while you’re not,” says DeMarzo.
He and his colleagues have thus found that the traditional economic assumption that people are driven by the straightforward desire to maximize their wealth is simplistic. Once actual consumption decisions are considered, peer pressure also comes into play.
“We might classify behavior based on relative wealth as ‘irrational,’ but in choosing similar, risky portfolios, investors are actually doing what makes sense to them,” says Kremer.
The researchers have found that investors tend to herd particularly around high-tech investments that have the potential to revolutionize the entire market and promise a big upside—technologies like fiber optics, internet-related infrastructure, and so forth. “These are typically high-risk stocks that, in seven out of eight cases, are likely to go bust. But people are willing to invest in them in the hopes that they’ll hit that one-in-eight jackpot,” says DeMarzo.
This phenomenon explains how stock bubbles emerge. When people begin crowding to certain investments, the price of the assets they hold become overinflated. The standard model says that if stocks are overpriced, smart investors will sell or avoid such investments. But DeMarzo and Kremer find that even if people know a stock is overpriced, their fear of doing something different from their peers and potentially losing out makes them move in ever greater numbers to the swelling investment.
Firms’ decisions to invest follow suit, the researchers have discovered. In the late 1990s, telecommunications companies, for example, overinvested in droves in fiber optics. Because they ended up laying far more lines around the country than were needed, by 2003 the value of fiber-optic networks fell by more than 90 percent from its all time high. Telecommunications companies accounted for 60 percent (by net worth) of U.S. corporate bankruptcies.
For individuals, herding can also provide a kind of buffer when the bubble bursts. “If everyone loses his or her money together, it’s perceived as not as bad as if just you alone lose,” says DeMarzo. Thus the “keeping up with the Joneses” school of investing has benefits on the upside as well as the downside.
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