Investors Fear Doing Poorly Among Peers More Than They Fear Risk According to Stanford Business School Research.

STANFORD, Calif. -- Why do people herd around risky investments, causing "bubbles" that inevitably burst and leave most investors losers in the game? Couldn't the players in the dot.com bust, for example, have seen disaster looming on the horizon? Why did more investors not get out earlier, and why did they continue to pump money into already over-inflated stocks? Similar questions surround the recent bust in the subprime mortgage market.

Two Stanford Graduate School of Business researchers say that what investors fear the most is not the risk of a loss per se, but the risk that they may do poorly relative to their peers. That means even though investments in areas such as new technology may be particularly risky, investors tend to cluster around such pie-in-the-sky opportunities to avoid being the only one in the neighborhood to miss out on the "next big thing."

In three related theoretical studies, Peter DeMarzo and Ilan Kremer, along with Ron Kaniel at Duke University, have discerned that individual investors care deeply about how their level of wealth compares to that of others in their peer group and community. "Investors fear being poor when everyone around them is rich," says DeMarzo, Mizuho Financial Group Professor of Finance at the Stanford Graduate School of Business.

A primary reason for people's concern, they explain, is that the cost of living in any community may depend on the wealth of its residents. The more money people have, the more expensive houses, real estate, daycare, and other necessities and amenities will be. "It's worse to have a lower income in an area where everyone is wealthy than it is in an area where everyone has a similar income as you," says Kremer, Associate Professor of Finance at Stanford Business School.

Using economic models, the researchers have discovered that such external worries have implications for how people invest. Specifically, they motivate people to choose portfolios that look a lot like those of others in their community or professional cohorts. "Such herding around certain investments allows you to combat the fear that everyone else might be betting on the winner while you're not," says DeMarzo.

He and his colleagues have thus found that the traditional economic assumption that people are driven by the straightforward desire to maximize their wealth is ...