One of my favorite investing books is, The Little Book of Behavioral Investing – How Not To Be Your Own Worst Enemy, by James Montier. The book takes you through some of the most important behavioral challenges faced by investors. Montier reveals the most common psychological barriers, clearly showing how emotion, overconfidence, and a multitude of other behavioral traits, can affect investment decision-making.
One of my favorite parts of the book comes from Chapter 14 – Inside The Mind of A Lemming. Montier writes about the psychological difficulty of being a contrarian investor and the pain of going against the crowd. It provides a great illustration of what’s happening inside our brains when we’re making contrarian investment decisions. Fortunately, although painful, a strategy of being contrarian is integral to successful investment. As Sir John Templeton put it:
“It is impossible to produce superior performance unless you do something different from the majority,”
Here’s an excerpt from the book:
AS WARREN BUFFETT OBSERVED, “A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth.” Of course, this is a highly defamatory statement with respect to lemmings.
A willingness to subjugate one’s own thoughts for those of a group is a sadly common behavioral affliction. Take a look at the four lines in Exhibit 14.1. Your task is to pick which of the lines on the right most closely matches the line on the left.
EXHIBIT 14.1 Pick the Line
If you are like most people this won’t be a huge challenge. One of the lines is clearly too short, one is obviously too long, and one fits the Goldilocks outcome of just about right.
But what if you were in a room with seven other people, each of whom declared that the longest line was the closest match? Would you stick to your guns or would you bend in the face of a clear unanimous majority?
Of course, a rugged individual like you, would stick to their guns, right? Well, the evidence casts serious doubt on people’s ability to maintain their independence in the face of pressure. Experiments like the one on page 168 have been relatively commonplace since the 1950s. The basic setup is that you are one person in a group of eight or so. Unknown to you, the other participants all work for the experimenter. The room is set up so that each subject gives his or her answer in turn, with the one true subject always going last.
Under these conditions, psychologists have found that people conformed to the incorrect majority view approximately a third of the time. Three-quarters of the subjects conformed on at least one round, and one-third of the subjects conformed on more than half of the rounds.
Interestingly, experiments have found that varying the group size has virtually no impact on the likelihood of someone conforming. As soon as there were at least three people giving an incorrect answer, then about one third of subjects started to conform to the group judgment.
Recent evidence from neuroscientists further increases our understanding of what is actually happening when people conform. Rather than using the straightline test, the researchers used a 3-D image rotation task, in which two images are shown and the people have to decide if the second image is a rotation of the first.
While harder than the simple straightline test, when people performed this test alone they did remarkably well, getting nearly 90 percent of the answers right. Unfortunately, a very different performance was witnessed when they could see the answers given by other members of the group. The rate of correct answers dropped to 59 percent —statistically no better than if they had flipped a coin to make the decision.
Being neuroscientists, this game was being played while the subjects were undergoing a brain scan (an MRI). The researchers found that when people went with the group answer they seemed to show a decrease in activity of the parts of the brain associated with logical thinking—the C-system. Simply put, they seemed to stop thinking.
Not only did participants stop thinking, but when a subject conflicted with the group a very specific part of the brain lit up—our old friend the amygdala, the brain ’s center of emotional processing and fear. In effect, nonconformity triggered fear in people. Going against the crowd makes people scared.
Not only does going against the herd trigger fear, but it can cause pain as well. In this experiment, participants were told to play a computer game while having their brains scanned. Players thought they were playing in a three way game with two other people, throwing a ball back and forth. In fact, the two other players were computer controlled.
After a period of three-way play, the two other “players” began to exclude the participant by throwing the ball back and forth between themselves. This social exclusion generated brain activity in the anterior cingulated cortex and the insula, both of which are also activated by real physical pain.
Doing something different from the crowd is the investment equivalent of seeking out social pain. As a contrarian investor, you buy the stocks that everyone else is selling, and sell the stocks that everyone else is buying. This is social pain. The psychological results suggest that following such a strategy is really like having your arm broken on a regular basis—not fun!
Fortunately, although painful, a strategy of being contrarian is integral to successful investment. As Sir John Templeton put it, “It is impossible to produce superior performance unless you do something different from the majority,” or as Keynes pointed out “The central principle of investment is to go contrary to the general opinion on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.”
Research shows that Templeton and Keynes were spot on. The stocks institutional fund managers are busy buying are outperformed by the stocks they are busy selling. For instance, if stocks are assigned to different portfolios, based upon the persistence of institutional net trade (that is, the number of consecutive quarters for which institutions are net buyers or net sellers is recorded), and then the performance of the portfolios is tracked over a two -year time horizon, there is a 17 percent return difference—the stock that the institutions sold the most outperformed the market by around 11 percent, and the stocks they purchased the most underperformed by 6 percent.
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