The Dangers Of Groupthink For Your Investments

Published in Investing on 9 March 2012

Is it truly possible for your psyche to go against the herd?

Most of us like to think we're independent thinkers. But most of us simply aren't.

It's probably true to say that most private investors think they're good at analysis -- weighing the pros and cons of any potential investment opportunity and arriving independently at their decisions to buy/sell/hold etc. I say "probably" as, if they weren't, they probably wouldn't be private investors in the first place (to be clear, I'm talking about people who have a very significant proportion of their wealth in investments they've decided upon themselves).

Presumably, those of us who do this investing business reasonably successfully over an extended period aren't a representative sample of the population. To persevere at this game would be illogical if we didn't beat the market over time. Such illogicality doesn't rule out participation, of course, but it seems likely that we're capable of the independent thoughts and decisions necessary to beat the average in this one particular field. If not, why bother, unless you simply love it for its own sake?

Slightly different from the rest

And if this is true, then we're slightly different from the rest. Here's why:

A landmark psychology experiment conducted by American social psychologist Solomon Asch demonstrated just how most of us homo-sapiens are wired in to run with the herd. The experiment saw groups of people being tested for what they were told was their visual acuity. They were shown three straight lines of different lengths and asked which matched a fourth line in length. The answer was very obvious. But the test was really always about one individual; the rest of the group were actors all of whom had been instructed to give the wrong answer.

This tended to throw the individual actually being tested into confusion. Most such participants began to feel unsure, and to be swayed by the group's opinion. In fact, around 75% of people allowed themselves to be swayed in this way...

In other words, no matter how independently minded we all think we may be; most of us just aren't. It's very difficult for us humans to swim against the tide of popular opinion, no matter how erroneous that opinion may be.

In later similar experiments, brain scans have revealed that the desire to go along with a group is so strong in us that it can even alter the way actually see things in tests.

Sensible or crazy to break rank?

Interestingly, though, Asch also found that the group depends on unanimity. When he added a fellow 'dissenter' who gave the right answer, arguing against the rest, the real participant being tested almost always found the courage to speak up, too.

Even more interestingly, an experiment conducted by American Psychologist Vernon Allen found that people feel more free to break from groupthink when there is a dissenter in it who is demonstrably and obviously wrong in their opinions. In fact, 97% of participants conform to the group view without such a dissenting voice (albeit a 'crazy' one) versus 64% with their presence!

In other words, it's exceedingly hard for most human beings to stand up against the group. Our desire to please others and conform is deeply ingrained. The same is true of investors; those who are human, anyway. Perhaps a computer or automatic investing system of some kind can make us be independently minded, but otherwise it's hard.

People -- here, investors -- who can consistently reveal their own opinions and go against the group are known as iconoclasts. These are people like Ben Graham and Warren Buffett. They're people who are more immune than the rest of us from peer pressure.

You see these fascinating aspects of human nature being played out on discussion boards continually. It also helps explain why markets tend to overshoot. The challenge lies in recognising this innate human weakness and finding our own ways to fight against it for the good of our investments.

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Comments

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tux222 09 Mar 2012 , 5:43pm

Going *against* the herd will often get you squashed.

An image I find useful is to imagine that you want to cross a road along which a large demonstration is proceeding. You don't share the herd's goal, but the best way to reach your own goal is to march with the herd while working your way from one side to the other. Then go your own way again.

goodlifer 09 Mar 2012 , 8:32pm

It seems to me that the easiest way for an investor to be a bit of a contrarian is to invest for dividends - that way you're still part of a group, albeit a minority one.

I'm pretty sure most people invest for capital growth.
It so, the price of a share depends much more on Mr Market's assessment of its prospects for growth than on its yield.

This means that a high yield, low growth share can sometimes be seriously undervalued.

Which means a nice fat dividend, which ought to keep you happy.

It's also on the cards that Mr Market may have yet another brainstorm and decide that your high yield share is, after all, a high growth one, and seriously overvalue it.

A win-win situation?

SevenPillars 10 Mar 2012 , 12:12pm

This is a difficult one, because surely in markets the trend is your friend regardless of whether you believe it to be right or wrong? Try being contrarian and going against a well set trend that the herd is pursuing. You might eventually be right, assuming your bank balance can take the initial "paper" losses, but often you can get wiped out. The real art is not so much to be a contrarian, but conditioning yourself to not totally commit yourself to any position. If you can master this then you can go with any trend and hopefully be out before, or shortly after it changes. Admittedly this is difficult to do, in part because of the groupthink mentality that supports trends. You see it in all bull and bear markets, but I'm not convinced there is an alternative answer.

geddinquick 10 Mar 2012 , 9:48pm

The article isn't intended to encourage a contrarian approach - simply independent thought. So you could think independently from the crowd and still come up with the same conclusions as the majority - or not as the case may be.

goodlifer 10 Mar 2012 , 11:01pm

SevenPillars

"This is a difficult one, because surely in markets the trend is your friend?"

Why?

tru2me 11 Mar 2012 , 12:48pm

David thank you for an interesting & very relevant article.

Life is not necessarily easy in many respects for those of independent thought. After all the herd, is often against the individual.

One thing maybe, that goes hand in hand with the above is the ability to think laterally. A small or maybe not so small but key point, missing from your article.

Although lateral thinking is a subject maybe to be covered in conjunction with or as part of a series of ...

IMHO I suspect the key to much of this subject is the way individuals have been parented or brought up. Therefore how that reflects on an individuals outlook in life.

goodlifer 12 Mar 2012 , 8:48am

geddinquick

"So you could think independently from the crowd and still come up with the same conclusions as the majority - or not as the case may be"

Quite so - in theory.
In practice?.

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