# Rational Herds, from Victor Niederhoffer

January 20, 2013 |

The book Rational Herds: Economic Models of Social Learning by Christopher Chamley has many stories, models, and algorithms, that are helpful for gaining insight to markets. The stories start with the penguins standing on the edge of the ice, needing to get food but not knowing whether a killer whale or seal is waiting for them underneath. The first penguin to dive in provides much information for all the others. But it's not advantageous for him. The asymmetry between what's in the interest of the individual and the group and the advantages of social learning are readily seen by this example. The solution is for the other penguins to push the unlucky one in. The analogy of running the stops in markets with the first one to do so possibly losing money, but the others all gaining from the information is seen.

Another story is based on yellow cabs being 90% probable in a city. But an accident happening and the observer saying it was a red cab that caused it. Problem is that the observer's is only right 4/5 of the time. Bayesian analysis shows that after the first observation it's 9/13 that the yellow cab hit him. But after two reports the probabilities drop to around 48. The rate of convergence to red versus yellow follows a definite process which leads to all sorts of implications for cascading, herding, randomness, and social learning. Many examples of investment decisions based on following the leader and false decisions making from random events are given.

One wishes that the author would have followed some of the stories that motivated the book and shown how all the formulas would work for the simple examples above. The book is intended mainly for economics, social psychologists, finance people, and statisticians. But it's also relevant for anyone interested in how information travels. It's not easy reading and requires pencil and paper and working out a few examples to get much benefit from it.

I alternated reading it with modern times, and books on plants in my recent visit to Chicago. Glad to be back with you.

## Jim Sogi writes:

Sitting in LA traffic a few days ago got me thinking about individuals in a group. Ants probably think they are pursuing their own individual interests to be fed, to be safe, to have friends. But looking down on them from above shows a different picture. Each car in traffic has their own individual desire and plan but looking down at traffic patterns shows a different picture. Each investor or speculator has their own reason to buy or sell, for ex, personal reasons, business, family, taxes. But looking at the aggregate shows a different picture.

## Gary Rogan writes:

Worker ants can't reproduce and cant think. Their only genetic purpose is to help the colony survive so that the queen propagates her genes by producing a relatively small number of fertile descendents. Human beings can think and reproduce, thus even genetically they have a very different purposes, closer to the ant queen but with thinking abilities. Their natural goals are not those of the collective.

I've come to think that perhaps no human can step out of the herd no matter how hard he or she tries. While there are many who realize the disadvantages of herding in a modern society and try to break free, they nevertheless follow another herd, trying to break away from the traditional ones.

I was thinking about this the other day. We understand how cells serve the functioning of our lives. They are alive themselves but work selflessly in ways defined for them to serve the body and mind. Can they be said to be herding?

Are we here to serve some upper life like ants serve the colony? That is a hard question, but if it were true, perhaps herding would be not only inevitable but also necessary. It would ensure we live by the rules, which are the only basis for our lives. By that logic, being selfish would only serve ourselves negatively.

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