I’m currently reading a well written book entitled How Markets Fail: The Logic Of Economic Calamities by John Cassidy, a journalist at the New Yorker magazine which I would highly recommend to my clients and others who like to assimilate new ideas. In the book Cassidy describes the major influence of what he describes as Utopian Economics, thinking that is blind to how real people act, how this leads to market bubbles such as real estate crashes and credit crunches, and explores behavioral economics which focuses on individual behavior biases – overconfidence, envy, herd behavior, and myopia – and how they lead to some troubling macroeconomic behavior that affects all of us.

I’m at a part of the book where Cassidy a paper done in 1990 by David Scharfstein of MIT and Jeremy Stein of Harvard entitled “Herd Behavior and Investment”. The core of their model basically says that if an investment manager goes with the crowd (i.e., invests in the same stocks as other investors) and things turn out badly, he gets to share the blame with everybody else; if he follows a contrarian strategy, he bears the sole responsibility for his mistakes. After the Sharfstein-Stein paper was published, other researchers provided empirical evidence that supported it by analyzing the hiring and firing of fund managers at Fidelity, Franklin-Templeton, and T. Rowe Price. A similar pattern was found in the hiring and firing of Wall Street security analysts – the ostensibly objective professionals who produce quarterly earnings forecasts that investors rely on.