Individually bright, collectively dopy

Everyone knows that investment is as much about psychology as economics, but rarely are the two disciplines brought together. Indeed, while there has been a vast amount of work done linking economics and financial markets, perhaps too much, there has been relatively little on the psychological side of investment.

This shows in the lack of study of phenomena like the herd instinct. Any professional investor will know the peer pressure that exists - the desire, among fund managers and economic forecasters, not to be too different from the norm even when the norm is obviously at an extreme by historical standards.

In the case of economic forecasting this may matter little, because everyone knows that forecasts will be wrong and aims off accordingly. But in the case of investment there are actual decisions to be made, not forecasts about the timing of the recovery or whether interest rates will rise or not. In the past few years the herd instinct of investors has even been institutionalised by the spread of investment advisers and consulting actuaries.

In Britain the actuaries have become the kingpins of the investment management business, running beauty parades for pension funds wishing to choose new managers and insisting that funds do not deviate from the market average. The effect has been that even when investment managers think a market has topped out and wish to move back to cash they are not allowed to do so.

The actuaries will doubtless rule for a while yet, but at least the herd instinct is starting to attract critical attention. This week a conference has been taking place at the Cambridge Center for Behavioral Studies in Massachusetts on 'Behavioral economics for financial decision makers', which has set out to explore the relationship between behaviour and investment.

The opening speaker was Henry Kaufman, who now runs his own financial consultancy firm but who made his name at the New York investment bankers Salomon Brothers. It was there that he was dubbed 'Dr Doom' because he rightly went bearish on bonds during an earlier interest rate cycle. At this seminar Dr Kaufman made four observations about the behaviour of economic and financial forecasters.

First, most forecasts stayed within a narrow range - 'There is comfort in being with the crowd' - with the result that big changes in economic or financial behaviour were spotted only by a few.

Next, many projections take for granted that past cyclical patterns will be repeated. Dr Kaufman cited the misreading of the last expansion in the US - which was much more sluggish in the early stages than in previous cycles - as an example of the failure to see that there were special factors, including the debt load, that would make it different.

Third, negative forecasts were unwelcome, with the result that there were few official forecasts of recession and few investment houses forecast sharp falls in financial markets.

And last, even if one had correct economic forecasts, few would have the capacity or self-confidence to take advantage of these.

These factors make market operators behave rather differently now than they did 20 years ago. For example, the growth of the institutions and of indexing has meant that the investment community is more risk-averse than it used to be. But paradoxically this has increased the possibility of sharp changes in the market if attitudes of these risk-averse people all change at the same moment. There has also been a rise in emphasis on short-term performance and on specialisation.

The result of the latter feature is that clients have to make the most important decision of all, which is to allocate their funds wisely between different classes of assets. And the emphasis on short-term performance has encouraged investment in the exotic end of the derivative spectrum, without the risks being fully understood.

Many investors will take comfort in these thoughts - and perhaps also in Dr Kaufman's parting shot. This was that at this point in the US cycle many market operators were biased towards assuming that the latest tightening of interest rates would be the last, even though on historical grounds this seemed unlikely.

Other speakers at the conference looked at different aspects of investment psychology. Among these were Professor Andrei Shleifer, of Harvard University, who delivered a speech on contrarian investment, Professor Richard Thaler, of Cornell University, who spoke on the fact that investors were still prepared to hold bonds as well as equities even though equities have delivered vastly higher returns over the past 100 years, and Charles Munger, of Berkshire Hathaway, the famous 'long-term' investment house founded by Warren Buffet, who discussed why investors make bad decisions. There was even a speech by Professor Paul Samuelson, Nobel prizewinner and teacher of economics, through his text-book, to generations of undergraduates.

What is surely most interesting about all this (aside from the fact that in the US, unlike Britain, serious economists seem happy to get their hands dirty by writing about investment) is that academics are challenging the standard nostrums of the investment banks. Despite all the energy, money and talent that goes into fund management the professionals still end up doing dopy things. Individually they may be bright, but collectively they deliver the wrong answers.

For thoughtful long-term - which often means contrarian - investment management one has therefore to go to investment boutiques, often run by one talented individual, rather than one of the famous names of the industry.

Up to now these people have been operating pretty much in an intellectual vacuum. They send out their newsletters to their clients and make their fees. But there has been no back-up from the heavy guns of academia. That is why this conference is so helpful.

There is, however, one small consolation. If the professionals display the herd instinct, that leaves much more scope for the amateurs. On the face of it, private individuals working with share prices a day old in their newspaper and no in-house economists to brief them have no chance against the screen-driven dealers. But if the professionals act like sheep, there is all the more room for the canny individual who is brave enough to head in the other direction.