16
Jul

Rational herding, the answer to many questions

Escrito el 16 julio 2007 por Juan Toro en Financial Markets

Rational herding offers an explanation to the recent sub prime meltdown. The question is why a bunch of well trained investors ignored the warnings about an overheated and overdone market? The reason is that in any bubble type environment it pays off to follow the crowd, even if investors acknowledge wide risks. Because many investors are judged on relative terms, they might be better off fully invested regardless of the fundamentals, to avoid potentially been caught wrong relative to their peers. We have seen that a bubble can go on for longer that expected and it is difficult to predict the inflection point. The dot com bubble went on longer than many predicted and even those who judged it right were badly hit because of wrong timing. One example of this was the Tiger Fund that sold the market much before its sharp decline. Rational herding explains why many investors herd the market even if they know it is unsustainable based on fundamentals. Still it is difficult to distinguish among rational and irrational herders. However, the formers even if they follow the trend are probably more prudent on their risk taking.

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