Bandwagons quickly become very powerful, resulting in a streamlining of thinking, an over-simplification of complexity and the erasure of nuances, in effect commoditising ideas.
Successful bandwagons usually hold great emotional appeal, either because they lean on deep-seated market prejudices, or because they assign great structural importance to market moves that in many cases are merely technical in nature. This gives bandwagons the power to move large numbers of hapless investors in the same direction at the same time. A good analogy is a bunch of three-year olds playing soccer: picture ten kids in a headlong mass chase after the ball.
Bandwagons have risen to prominence out of necessity, the mother of all invention. They have become a replacement for structural changes, conventional business cycle dynamics and monetary policy changes, both of which have become scarce since 2008/2009.
Bandwagons are popular both among market makers and the media, because they can be used to persuade a critical mass of investors to move, thereby engaging the enormous volumes of liquidity trapped in financial markets since the onset of QE policies.
There also appears to be a somewhat cynical exploitation of investor myopia going on: many investors are finding that their economics education and past experiences offer little guidance in today’s unprecedented macroeconomic conditions. This makes them more inclined to believe in fairy tales.
Finally, regulatory pressures have undoubtedly helped to concentrate more and more money into narrower and narrower sets of securities, especially developed country bonds and stocks.
Deep-seated prejudices
Bandwagons exercise an outright tyranny on markets when they feed on deep-seated prejudices instead of sober analysis; indeed, the rationale for several of most important bandwagons of recent times has been extremely tenuous and entirely baseless ex-post.
Bandwagons drive trading volumes and market volatility unnecessarily high, increasing revenues for market makers, but offer no value for strategic investors. They also prey on those with weaker convictions, sucking them into their vortex, while stronger, more independent investors can experience considerable challenges in sticking to their positions, even if they are right, until a bandwagon has run its course. Bandwagons encourage momentum trading over value investing.
Not only is this inefficient, it is also outright dangerous and ultimately fruitless for the majority of participants who end up chasing the market and more often than not buying at the top and selling at the bottom.
By discouraging individual thinking, bandwagons create systemic macro risks through the homogenisation of investor behaviour. Emerging Markets (EM) investors are not immune; recent Morningstar data shows that tracking errors for US-based EM local bond market managers have halved since 2009.
What adds a particular sinister twist to the commoditisation of ideas is that it has coincided with the commoditisation of trading. Long-gone are the days when markets evaluated individual investments on their merits, that is, analysed investments on a case-by-case basis to determine if the expected returns warranted the money put at risk.
Today, most investors pool enormous numbers of individual investments into convenient buckets called asset classes, where they are given weights and benchmarked in indices that are then conveniently labelled as ‘the market’. The commoditisation of trading is risky, because investors tend to lose sight of the risks in the underlying investments. The tools used to alleviate this problem only provide a false sense of security.
Ratings agencies tend to miss big problems and act late. Classification of some securities as ‘risk free’ only ignores the problem of risk, thus increasing the unperceived risk. Finally, the commoditisation of trading means that investors miss out on all those opportunities that are not captured in benchmark indices (this is a particularly big problem in EM, where there are major market failures in index provision).
The best way to avoid these pitfalls is to get back to the basics of investing: adopt a value investment approach, maintain a strong credit focus, think independently and follow a medium to long-term investment horizon.
