Herding behavior: Why, so what and what if?

A news story from yesterday's Wall Street Journal on hedge funds and their herding behavior provides a good starting point for this discussion. In summary, the article notes the following:
(1) Hedge funds seem to buy and sell the same stocks, at the same time, and track each other's investment strategies.
(2) The correlation across hedge funds has increased over time. Hedge fund managers copy each other more than they used to.
(3) Hedge funds collectively are under performing the S&P 500 by more and more each year; for 2010, hedge funds generated 10.4% in returns and the S&P 500 earned 15%. On this point, you can take issue, arguing that hedge funds (or at least some of them) are less risky than the market and that the hedge funds may not lag the market on a risk/return basis. However, there is no denying that even on that dimension, hedge fund performance has deteriorated over time. I am not surprised by any of these findings, since they are consistent with existing research.

Why is there herding behavior?
We see herding in all aspects of human behavior, not just in finance. We tend to wear what other people wear, eat where other people eat and congregate in places that attract the biggest crowds. Herding may be more researched in finance than in other areas, but it is not unique to finance. Here are some reasons why herding is common.
a. Evolution instinct: It is not hyperbole to note that we have survived as a species by following the crowd. A cave person, when confronted with a crowd of cave people running in the opposite direction, would have been well advise to turn tail and run with them. Odds are that they were being chased by a mammoth. That instinct is still deeply embedded in our psyches. Faced with a wave of panic selling or buying in markets, it is very difficult to not join in.
b. Safety in numbers: Remember when you were a child, doing something stupid with a group of your friends. Odds are that when queried about your behavior, you used the standard excuse, "that they were all doing it". Put in analytical terms, a portfolio manager or CFO who makes a mistake is more likely to escape the consequences, if others make the same mistake, but will be punished if he or she is wrong alone. Think of all those bank equity research analysts who had buy recommendations on Lehman in 2007, who are still equity research analysts...
c. Information:  Assume that you are in a city you have never been in before and that you are looking for a restaurant to eat dinner at. Watching where the locals eat does give you information; you want to avoid the empty restaurants, because they are empty for a reason.
d.  Absence of competitive edge: It is easier to stand alone, if you know something that others do not or have a unique skill that gives you a leg up on the competition. The hedge fund story is revealing. Note that the herding behavior has increased as the hedge fund business has grown and collective performance has suffered. Much as we like to attribute superior skills to hedge fund managers, the herding behavior suggests that the average hedge fund manager has no competitive edge to speak off and seems to know it.

What are the consequences of herding?
If herding is a fact of life in both portfolio management and corporate finance, here are the consequences.  
In portfolio management: The bunching up of buying and selling on the same stocks will increase correlation over time in stocks (serial correlation), as an up day on a stock will attract more buyers in the near term, resulting in more up days. This will make momentum strategies more lucrative, at least in the short term. It will also make pricing bubbles and corrections more extreme and the latter will lay waste to the momentum strategies that looked so good before the correction. That "random walk" down Wall Street just became a lot more like a drunk walking down the street, overshooting in both directions.
Corporate finance:  If CFOs indulge in herd behavior, corporate financial practice will reveal "me-too" characteristics. In terms of financial policy, companies will try to set dividends and debt policy to be as close to their peer group as possible. If you are in a sector where everyone borrows money and pays dividends, you too will do so (even if you cannot afford to pay dividends or carry debt). An acquisition or buyback by one company is a sector should set off a wave of acquisitions and buybacks by other companies in the same sector. Not surprisingly, mistakes, when they occur, will be sector wide (like those telecomm companies that borrowed too much money in the late 1990s) or even market wide.

Can you take advantage of herding and if so, how?
 There are two strategies that you can adopt in a world where herding is the rule, rather than the exception:
a. The Yogi Bear strategy: The movie that just came out was disastrously bad, but Yogi Bear was "smarter than the average bear". To adopt the Yogi Bear strategy, you have to be smarter than the average investor. Essentially, you play the momentum game, reaping profits from herd behavior, but you get out just in time, before the correction hits. You get all of the upside of herd behavior and none of the downside. I had an extended post on momentum investing a while back, where I noted that while I don't think I can pull this off, there are others who can.
b. The Yoda strategy: Every investment sage will tell you that you should not be part of the herd and that you can make more money as a contrarian. Easier said than done. To succeed as an idiosyncratic investor, here is what you need:
a. A competitive edge: There is no point going against the crowd, if you have little to offer that is unique or different. It is a point that I have made several times before, but you need to bring something to the table before you bet against the crowd.  In Yoda's words: 
"You will find only what you bring in."
b. Self confidence: You have to believe in yourself. Without a core investment philosophy, it is difficult to hold on in the face of peer group pressure. As Yoda would say: “Do … or do not. There is no try.”
c. A patient client base: If you are investing for yourself, you have to answer only to yourself. If you are investing for others, you need investors who trust you to be right in the long term.