Janice Dorn, MD, PhD
Neuropsychological Trading Coach
Janice Dorn, M.D., Ph.D., has been a full-time futures trader since 1994. Doctor Janice holds an M.D. in psychiatry and is board-certified by the American Board of Psychiatry and Neurology in general psychiatry and addiction psychiatry. She holds a Ph.D. in brain anatomy. A graduate of Coach University, she is a pioneer market psychiatrist and financial neurobehaviorist. Doctor Janice has written over 500 articles on the financial markets and coached over 600 traders worldwide. She is the Global Risk Strategist for Ingenieux Wealth Management Group, Sydney, Australia.
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Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly and one by one…Charles MacKay
Yesterday morning, I was stunned to see ants crawling all over my kitchen counter. I chose to live on the top story of this building in the desert because I believed I would be less likely to see “critters” like ants and scorpions. For 10 years, this thesis worked for me. Yesterday, it stopped working. I am responsible for this, and here is why: The night before I saw the ants, I was in a last-minute rush to prepare a PowerPoint presentation for a webinar. Distracted, I left a small bowl of bran, flax and psyllium sitting on the marble-top counter next to the sink—a very unusual thing for me to do.
That one careless moment was enough to draw hundreds of ants, and I awoke to find them exploring every inch of my countertop. I immediately removed the source of attraction (the cereal), thinking they would go away. It didn't work: The ants seemed to be increasing, rather than decreasing in number. I didn’t want to kill them, so I tried to direct them down into the sink and run the water so they could find their way into the pipes—also not a good idea, but better than killing them…or so I thought. Clearly, this was not working, and I had to use lethal force to prevent my home from being overtaken. The ants just wouldn't stop coming, though it was to their doom. Why? The answer is what we call herding.
At the most simplistic level, herding describes the tendency of a species to seek safety in numbers. In the case of my countertop, it meant “follow the ant in front of you!”
Financial neurobehaviorists describe herding as the condition where a large number of investors or traders make the same choice based on the observations of others, independent of their own knowledge. In the markets, herding occurs when either positive or negative feedback prevails. Given that financial markets require a balance between positive and negative feedback, any imbalance or disequilibrium results in market inefficiency.
It is almost impossible to determine how much positive or negative feedback is enough. A large number of studies in this regard point to a critical threshold or tipping point beyond which either positive or negative feedback begins to dominate and to feed (pun intended!) on itself. This results in a widespread imitation effect that can lead to the development of either a bubble or a crash. (There are many experiments in physics that attempt to both identify and quantify financial imbalances that precipitate financial market crashes, but that is beyond the scope of this Trading Wisdom.)
Let us now return to the ants. Consider for a moment a most interesting situation that was described in army ants. A group of worker ants that are essentially blind are known to sometimes separate from the ant colony. Since no individual ant has any idea how to locate the original colony, they imitate; i.e., they follow the ant in front of them. This is a simple decision rule that can lead to interesting outcomes. If enough of these blind ants make the decision to follow the ant in front of them, a tipping point is reached. At this point, a circular mill of ants develops. Ants follow each other around and around in this mill until they die.
One fascinating example of this was a circular ant mill that lasted for two days. It measured 1,200 feet across and took 2.5 hours to circumnavigate. Eventually, a couple of the workers broke away from the mill, others followed and the mill began to break up.
Similarly, a great story about herding in the markets comes from Warren Buffett’s re-telling of a story from Benjamin Graham, who was one of Buffett’s mentors. The story goes something like this:
A wiley and clever oil prospector named Clem died and tried to get into heaven. In order to do so, he had to get past St. Peter at the Pearly gates. Once St. Peter found out that Clem was an oil prospector, he denied him entrance to heaven, pointing to a large group of oil prospectors that was waiting patiently to get into heaven, because there was no room. Clever Clem, never one to miss an opportunity, asked St. Peter if he could have a word with the other prospectors. Not seeing any harm in it, St. Peter agreed.
At that point, Clem yelled out to the other prospectors, “Oil discovered in hell!” Immediately, the group of prospectors ran out, looking to get to where the oil was. Yes, they were looking to get to hell in order to be near the oil! Seeing that the prospectors had all but disappeared, St. Peter told Clem it was now clear for him to enter heaven because there was plenty of room. Clem thought about it for a minute, looked at St. Peter and said, “You know, I think I am going to go ahead with the others. There might be some truth to that rumor after all!”
In finance, herding is a collective and contagious influence of investing or trading ideas in the financial markets. There are various types of herding behaviors, and I will address these in later Trading Wisdoms. I will also provide you with steps you may want to consider if you recognize that you are engaged in herding behavior to the detriment of your equity curve. For now, this introduction serves as grounding for a critical tenet of behavioral neurofinance and trading neuropsychology, and I trust it will stimulate you to think about your behavior the next time you place a trade or make an investment.
When I was an analyst…I placed too much stock in the opinions of others who seemed to know more than I did (my fault, not theirs). More unsettling, I saw others do the same with me…Henry Blodgett
Until Next Time,
Good Trading and (Revitalized) Brain On!
Janice Dorn, M.D., Ph.D.
janice@thetradingdoctor.com
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