Following the Herd: Why Traders Check IMs

BLOG: Analyzing actions of financial traders who buy and sell stocks, researchers find that trading in sync often increases profits.

Contrarians take note: The so-called “herd instinct” is often derided as something irrational and counterproductive, whether one is talking about financial markets or the rush to stampede out of a burning theater. But a team of researchers at Northwestern University’s Kellogg School of Management finds that traders acting in sync with one another are more likely to dodge losses. 

Tapping into more than two million instant messages sent between 2007 and 2009 by traders scrambling to buy or sell stocks in a fluctuating market, Serguei Saavedra, Kathleen Hagerty and Brian Uzzi -- respectively a sociologist, an engineer and an economist – found that the more these IMs come in waves, the more synchronous trading became. And the more traders followed the herd, the more likely they were to pick the right moment to buy or sell.

“For a long time we’ve known that people trade stocks based on information,” Hargerty tells Kellogg Insight. “If big news comes along, like a blown-up refinery in Libya, there’s a good chance people will trade on it. But it’s not like they just read the news and press ‘buy’ or ‘sell.’”

The Kellogg study found that as waves of IMs formed – as opposed to a random distribution throughout the day – individuals increasingly traded within seconds of each other and paused at the same time. What is notable about these trades is that they typically dealt with unrelated stocks, ruling out the idea that the market was directly guiding their choices.

As the study’s authors point out, long-standing problems are often solved simultaneously by various people working alone. Charles Darwin and Alfred Russel Wallace, for example, independently proposed the theory of evolution. French physicist Edme Mariotte independently landed on what is now known as Boyle’s law of gases without knowing that Robert Boyle had just done the same.

“In economic classes they tell you about variables, but they neglect emergent patterns,” Saavedra writes. “Instant messaging is part of traders’ daily routine -- one of many -- and our study says these daily routines actually have some kind of impact.”

“The idea that collective genius can surpass the intellect of a single person is very radical,” writes Uzzi. “But I think we are entering a time right now where there is a growing sense that collective dynamics may help us solve tough problems that a single genius simply can’t.”