Herd on the Street

By Justin Fox

In 1951, Princeton economics major Jack Bogle wrote a senior thesis extolling the virtues of the small but growing mutual-fund industry. At the time the reigning view of the stock market was that expressed 1 1/2 decades earlier by the great English economist (and speculator) John Maynard Keynes: it was a "casino," a "whirlpool of speculation," a "game of Snap, of Old Maid, of Musical Chairs." Young Bogle argued that the growth of professionally managed funds would bring a new age of calm rationality to the market and thus "militate against Lord Keynes' dismal and socialistic conclusions."

After graduation, Bogle went into the mutual-fund business, later founding the Vanguard fund family, now the country's second largest. As he had predicted, mutual funds became an ever bigger force--they and other institutional investors now own more than 70% of U.S. stocks, up from about 10% when Bogle wrote his thesis. Professionals managing other people's money dominate almost every financial market, from bonds to pork-belly futures to collateralized debt obligations.

Contrary to Bogle's prediction, though, the rise of the credentialed pros and commensurate decline of often ill-informed part-timers haven't stabilized a thing. This year we've seen the professionally managed market for mortgage securities travel from giddy abandon to deep despair in a matter of months, dragging other markets down with it. That's just this year: think back to the rise and fall of the dotcoms, the emerging-markets meltdown of 1997 and 1998, the bond crash of 1994, the stock crash of 1987. As Bogle put it a few years back, "Keynes one, Bogle nothing."

Bogle wasn't the only observer who thought the professionalization of the investment business would wean markets from manias and panics. In the 1960s finance scholars rallied around the idea that smart, rational professionals would keep prices for stocks and other financial instruments in line with their real values.

In recent years this academic faith has faltered, largely because of the realization that it's tough for the pros to do what it takes to keep markets rational. That's partly because they're human and thus subject to the same decision-making quirks as amateur investors. But the crucial limitation is that the professionals are mostly playing with other people's money. If they go against the crowd, they risk having that money taken away from them before their bets have time to pay off.

Keynes actually remarked on this back in 1936. "It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks," he wrote. "For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion."

For decades, though, this truth was ignored by those who studied markets. Only in the past decade has it made a comeback. The landmark academic work in this vein was a 1997 paper by Harvard economist Andrei Shleifer and University of Chicago finance professor Robert Vishny (who has since left Chicago to become a full-time money manager). Their argument focused on arbitrageurs who use borrowed money to bet that small market mispricings will disappear but who can't get banks to go along with their sometimes contrarian thinking and lend them money exactly when the mispricings--and thus the opportunities--are the biggest.

When this very dilemma toppled the hedge fund Long Term Capital Management and rocked global markets in 1988, Shleifer and Vishny were hailed as visionaries. Their paper helped spark a broader re-examination of the role of professional investors. Whereas professionals inject sophistication and expertise into markets, most of them are too busy trying to hold on to the money under their charge--or to their jobs--to keep things truly rational.

Since 2005, for example, experts had been arguing that mortgage-lending standards had grown unsustainably lax, that real estate prices couldn't keep rising, that a sharp housing correction was in the offing. They were right. But those who actually worked in the business of writing, packaging and investing in mortgage loans couldn't act on such concerns and expect to stay employed. There was too much money to be made running with the herd. Or dancing with it, as Citigroup CEO Charles Prince put it in a memorable July interview. "As long as the music is playing, you've got to get up and dance," he told the Financial Times. "We're still dancing." Now the mortgage-lending party is over, and housing markets may feel the hangover for years.

Can anything be done to halt such excess? Keynes proposed taxing financial transactions to discourage speculation, an idea that remains popular in antiglobalization circles but has never gained traction with U.S. lawmakers. Shleifer favors protecting consumers from some financial-market excesses--via mortgage lending regulations, for example--but is dubious of attempts to rein in markets themselves. Bogle has argued that professional investment managers wouldn't run off the rails so often if they were forced--by custom and by law--to place more emphasis on moral and fiduciary duty. The unavoidable reality, though, is that the pros simply can't be expected to be much calmer or more rational than the rest of us.