David S. Scharfstein

David S. Scharfstein is an economist whose research with Jeremy C. Stein examined herding among mutual-fund managers. Their explanation shifts attention from investment judgment alone to the managers’ need to persuade investors that their decisions are reasonable: under that pressure, following peers can be safer for a career than acting on independent information, even when imitation makes the market less informed.

Research on Herding

Scharfstein and Jeremy C. Stein studied the tendency of mutual-fund managers to follow similar strategies and converge on the same stocks. The behavior appears paradoxical: managers have jobs because they have persuaded investors that they can outperform the market, yet imitating competitors makes an already difficult task harder. Most managers, moreover, do not outperform.

Their analysis identifies a second task alongside investing wisely: managers must also convince clients that they are investing wisely. Investors cannot readily distinguish skill from luck. Short-term performance is an imperfect measure, since results in a given quarter can be strongly affected by factors unrelated to a manager’s stock-picking or asset-allocation ability. Faced with that uncertainty, investors can look to a manager’s peers as a rough test of whether the strategy seems rational.

Reputation and Career Incentives

A manager who invests in the same kinds of stocks and allocates money to the same kinds of assets as other managers offers investors a reassuring signal: the decision does not look irrational. The reverse is also true. A manager who bucks the crowd, perhaps by pursuing a contrarian strategy, risks being judged foolish before the results can establish whether the choice was sound.

That reputational risk matters because investors do not have unlimited patience, and even a skilled manager will perform poorly some of the time. It is therefore safer to choose the strategy that appears rational to peers than to risk a strategy that may be rational but looks unconventional. Managers seeking to protect their jobs consequently have a reason to mimic one another. The pressure does not require them to be forced into conformity; it arises from the difficulty of making independent judgment legible to investors and surviving the wait for results.

Consequences for the Market

Imitation undermines the information advantage it is meant to protect. Managers who copy others are no longer trading on their own information; they rely on information already reflected in other people’s choices. As they converge on similar approaches, the range of possible investments narrows, and fewer distinct judgments enter the market.

Scharfstein and Stein’s account thus connects individual career incentives to a collective loss. What can look like prudent, defensible decision-making for each manager can reduce the market’s overall intelligence: the crowd of professionals may arrive at similar choices not because their separate information has been combined, but because the incentive to appear reasonable has discouraged them from contributing it independently.