In 1990 two economists, David Scharfstein and Jeremy Stein published an article in The American Economic Review entitled “Herd Behavior and Investment.” This paper cited Keynes’ philosophy that “worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” The two economists created a mathematical model, which demonstrated that in some cases it is more beneficial for investment managers to mimic the actions of others opposed to trusting their own judgments. While the set up of their model differed from the Beauty Contest, the motivation behind the model was in essence the same. The model proposed the idea that if an investment manager goes with the crowd and things turn out badly, he gets to share the blame with everyone else. If he follows his own judgments and fails, he has to take full responsibility for his mistakes. Basically if you dosomething dumb, but so is everyone else, people won’t think you’re stupid and therefore your reputation won’t be ruined. Scharfstein and Stein were first motivated by the 1987 crash. They observed that leading up to the crash, the popular wisdom of fund managers was if I bail out, I might be the one guy who bailed out too soon. With this ideology, if everybody acts on their own opinion there would be a diversity of opinion in the marketplace whereas if everybody is following the group, when the group shifts everybody shifts. After Scharfstein and Stein published their model, other researchers began studiesthat provided evidence supporting this. Research was done analyzing the hiring and firing of fund managers at mutual fund firms such as fidelity, Franklin Templeton, and T. Rowe Price. Economists Chevalier and Ellison concluded from the results of the study that young fund managers who followed investment strategies that deviated significantly from their peers were more likely to lose their jobs regardless of how their funds performed. This threat of being fired gave fund managers a strong incentive to invest in popular sectors even if the fund manager believed they were overvalued. Another paper by Harrison Hong, Jeffrey Kubik, and Amit Solomon conducted research on the hiring and firing of Wall Street securities analysts. Securities analysts are workers who’s job is to produce quarterly earnings forecasts that investors rely on. Hong, Kubik, and Solomon concluded that inexperienced analysts who produced forecasts that differed significantly from the industry consensus tended to lose their jobs at higher rates. Because of this, the researchers also found that most young analysts tended to stick close to consensus forecasts. These findings put dents into the efficient market hypothesis.To review, the efficient market hypothesis is the belief that it is impossible to “beat the market” since stock market efficiency always incorporates and reflects all relevant information and that because of this stocks always trade at their fair value on the stock exchange. The efficient market hypothesis also claims that stocks move randomly.During the 1980s and ‘90s research was done that disproved the idea that stocks move randomly. Research showed that stocks do better in January than in other months and they also do better on Mondays opposed to any other day of the week. Small cap stocks outperform large cap stocks and that value stocks which are stocks with a low price to dividend ratio outperform growth stocks. Researchers also were able todemonstrate that successive movements in the market are correlated. Upward moves tend to come in clumps, as do downward moves. This is seen in not only price changes but also trading volumes and volatility. Fama himself coauthored two revisionist papers where he acknowledged trends in the stock market. One paper recognized the fact that stocks that traded at low prices relative to value stocks outperformed growth stocks. Another paper showed that more than a quarter of the variability in total market returns could be explained by looking at the initial dividend yield alone. This observation meansthat when a dividend yield is low, the stock performed badly in the following years whereas if the dividend yield was high, stocks performed well. Cassidy points out that while all of these findings discredit the efficient market hypothesis the stock market acts differently in the short-term opposed to the long term. In the short-term (days, weeks, andmonths) stocks do follow trends where winners keep winning, and losers keep losing . In the long-term the stock market shows both short-term momentum and long-term mean reversion. In response to this research many hedge funds now contain “momentum funds” which buy stocks that appear to be going up and hold onto them for only a short amount of time. This method of investing follows the crowd instead of estimating the fundamental values of the securities. Research shows that this strategy of chasing the winners where people buy stocks that have risen in the previous 3-12 months did much better than the average.The regularity of speculative bubbles has created interest in crowd psychology. While ideas of the Beauty Contest explains the irrational behavior of Wall Street Insiders in creating and sustaining bubbles, it doesn’t explain the behavior of the millions of ordinary traders also known as the noise traders who buy in at the top of the market. Psychologist Solomon Asch created an experiment demonstrating the prevalence of conformity in our