BENEDICT CAREY ESSA

Experts have long known that a classic phenomenon called herd behavior has a great deal to do with the wild swings of panic and exuberance that can seize Wall Street in the wake of surprising economic news.
But lately they have tried to confront a related question: What makes a herd, financial or otherwise, stop and turn around- Specifically, behavioral experts want to know if there are psychological cues that can help transform this bear market into a bullish one.
“The dynamics of these turning points are much harder to understand than the original herd behavior itself, perhaps particularly in economics, “and the field is only just beginning to look at them, said Terrance Odean, a professor of finance at the University of California at Berkeley’s Haas School of Business.
Researchers who study nonconformity, fads, even game theory, agree that in any declining market, investors will inevitably begin to bet against the behavior of the herd. Many of these initial contrarians may be working from their own analyses of economic fundamentals, or from tips, or maybe they are simply jumping at the chance to pick up “distressed products like mortgages and bank loans on the cheap.
But other investors will defect for individual, idiosyncratic reasons. Two recent psychological studies at Arizona State University point to what it might take for individuals to leave the herd. In the studies, researchers demonstrated that young men rating the attractiveness of facial photographs significantly changed their ratings, up or down, in line with what they thought were peers’ ratings (but were in fact generated by a computer program).
Yet when encouraged before- hand to think of meeting a romantic partner, the men were highly likely to dissent. “The goal to attract a mate generally led them to go against the preferences of others, the authors concluded.
Other sorts of strong urges can similarly overwhelm the social pressures to conform, some experts said. Investors trying to preserve their reputation as mavericks, for example, or to show confidence under spiraling pressure, might favor a contrarian strategy.
“When you’re working with other people’s money you’re going to be looking to hit for average and minimize risk, period, said Charles Osborne, president of Osborne Partners Capital Management in San Francisco. “But you sometimes see people who feel they have little to lose make a contrarian move; they may feel they’re going to lose the client anyway, and so bet against the crowd.
Early dissenters usually pick up allies quickly. One model that researchers have used to study contrarian behavior is called the minority game.
The game is based on a now-classic problem posed in 1994 by the economist W. Brian Arthur set in a bar called El Farol. Everyone likes El Farol but also knows that the place is not much fun when it’s crowded. What, then, is the best strategy to maximize the fun? Avoid weekends? Try Thursdays and Sundays? Won’t everyone else be doing the same?
Experiments testing various versions of this game have shown that many players flip strategies in the middle of playing, simply because they have set some private threshold for changing, like trying one strategy three times, “and if it doesn’t work, switch to the other one, said Willemien Kets, a postdoctoral fellow at the Santa Fe Institute, an independent research and education center in New Mexico.
Dr. Kets contends that this switching strategy can be successful precisely because others decide to stick to a congested road. The behavior “suggests that a variety of contrarian strategies will evolve naturally in the course of any such game because there are people who are more conservative in their strategies, he said.
Not that the market cares about any of this; it will destroy anyone who’s early, late or wrong .
But under the right circumstances, key investors and traders pick up on the same contrarian cues, and the herd can change course very quickly.
Those investors who stay in the business long enough know from experience who tends to be on the right side of trades, and who grazes with the sheep. And if the ratio of sheep to non-sheep in the neighborhood gets too high, they hop the fence out.
“People say picking where the market’s going to turn is all gut feeling, but that’s really a misnomer, said Tom Baldwin, a legendary trader in Treasury bond futures at the Chicago Board of Trade. “You don’t have to be the first one in. You’re really watching what certain other people do.
He added: “They don’t have to be huge, market-moving people, just traders you know from experience who tend to be right, and if you take the other side, you’re going to lose money. Then it’s a matter of believing what you see. You have to believe it, that’s the hard part.