Question

Keynes once stated that it is better to fail conventionally than to succeed unconventionally (herding). How does this saying possibly cause managers to act irrationally in terms of market valuations? That is, how might this statement cause a manager to invest more when the markets are clearly overvalued?

Answer 1

We live in an era of competition. Almost every business is cut-throat competitive, and every business manager is judged not only the basis of his absolute performance but also relative to the performances of competition in the industry.

Short-sighted decision making is a legend on wall Street where the decision makers are more concerned about the year end bonuses instead of long-term business growth. This was believed to be one of the causes of 2008 financial crisis, as was also predicted by an IMF report back in 2006, raising questions of CEO/top management bonuses linked to yearly performances leading to irrational decison making by the management.

Irrational decision making in times of overvaluation:

The times of excesses/overvaluation tends to continue for an extended period of time. Everything feels bullish, the whole industry is investing big, the expectations of stakeholders are high and management is under pressure to keep the momentum going. The conventional decison making takes over rational decision making.

The ambitious acquisitions/investments made by competitors put pressure on the management to do the same and it becomes very tough for managers to be the party spoiler (acting bearish) in those times. This is why they say that the worst acquisitions/investments happen at the peak of Bull run. Because the valuations are constantly rising, the recent acquisitions in the industry give an impression of working well and that puts pressure on managers to do the same. Pressure to do what's conventional rather than rational. Let's take an example:

Example: Shale oil boom

The oil price boom took oil prices to above $110 per barrel in 2014. This level of overvalued oil prices made many players to invest in shale oil extraction and production. The shale required expensive extraction technology but the booming oil prices made investors not care as new investors were herding in for the shale opportunity and the party was expected to continue as shale extraction was perceived to be a profitable venture at $100 oil price. More and more shale companies came into business as conventionality took over rationality. However, as it turned out, the oil price saw one of the biggest declines in its history in 2015-16 and many shale players went looking for shelter. This was a classic example of over-ambitious investment policies in the times of overvalued markets.

How the statement cause a manager to make irrational decision?

Keynes' statement just shows normal human perception that it's considered fine to make a mistake that everyone around is making, rather than going against the crowd and making decisions that seem against the common belief. Investors like to go where the wind is going and things seem to be working, rather than making decisions that look against the prevailing sentiments.

Therefore, as explained above as well, the competitive pressures, focus on short-term performance, and comfort with conventional decision making causes a manager to invest more when the markets are clearly overvalued.