Keeping your head in times of turmoil

Herding

The urge to do what everyone else is doing

Philip Fisher points to the “… inherently deceptive nature of the stock market. Doing what everybody else is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do at all.” (Fisher, 1958,1996)p.32.

Who was Fisher? On November 15, 2013, Warren Buffett met with University of Maryland MBA Students. In notes taken by Professor David Kass, Buffett acknowledged that along with Ben Graham, Fisher was one of the great influences on his approach to investing, particularly as to how he viewed companies.

Regarding being a contrarian, Fisher wrote: “Contrary opinion, however, is not enough. I have seen investment people so imbued with the need to go contrary to the general trend of thought that they completely overlook the corollary of all this which is: when you do go contrary to the general trend in investment thinking, you must be very, very sure that you are right.” (Fisher, 1958,1996)p.243.

Self-reliance and independent thinking are tested in a crowd. Philip Fisher wrote: “A basic ingredient of outstanding common stock management is the ability neither to accept blindly whatever may be the dominant opinion in the financial community at the moment nor to reject the prevailing view just to be contrary for the sake of being contrary. Rather, it is to have more knowledge and to apply better judgment, in thorough evaluation of specific situations, and the moral courage to act ‘in opposition to the crowd’ when your judgement tells you are right.” (Fisher, 1958,1996)p.277.

Groups, crowds, committees and other dangerous animals

Shiller reports on experiments by Morton Deutsch and Harold Gerard which examined the question whether crowd behavior could be explained by social pressure within the group or the fear on the part of one member of the group of being seen as foolish or different.

The explanation they came up with is that an individual in a group tends to accept the views of the rest of the group because they simply think the others can’t be wrong.

Keynes chafed with the investment committees he dealt with. In The General Theory he wrote: “…it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion.” (Keynes, 1936,2007)p.158.

Keynes also wrote: “When I can persuade the Board of my Insurance Company to buy a share; that, I am learning from experience, is the right moment for selling it.”

The Groupthink phenomenon is surely in part the reasoning behind John Templeton’s Maxim 21 which reads: “The best performance is produced by a person and not by a committee.”

In so many ways it is easier to work alone than as part of a group. It is a reality of investing that mistakes will be made. Things will not go as expected. The trick is to learn from these experiences. It is more difficult for a committee than an individual to face and learn from mistakes. Committees become involved in blame games. If an individual is working alone they don’t have to face the embarrassment of admitting to a mistake in front of others.

We defer to people we assume are expert

Other experiments highlight the ‘enormous power of authority over the human mind’. The conclusion as described by Shiller is that: “The experiments demonstrate that people are ready to believe the majority view or to believe authorities even when they plainly contradict matter-of-fact judgment. And their behavior is in fact largely rational and intelligent. Most people have had many prior experiences of making errors when they contradicted the judgments of a larger group or of an authority figure, and they have learned from these experiences.”

It is to be noted that Shiller is here referring to reliance on views considered to be authoritative or having expertise. This would be in contrast to reliance on an authority figure, i.e. a person in authority.

Shiller concludes: “it is not at all surprising that many people are accepting of the perceived authority of others on such matters as stock market valuations.” (Shiller, 2005 Second Edition)p.159.

‘Authorities’ include the stock analysts whose reports we have access to through our brokers. They are also the analysts, market commentators, money managers quoted in the press, and any number of self-styled experts. The level of expertise of authorities or experts varies enormously, from a lot to hardly any at all.

Experts and authorities are susceptible to the herd

Recall Fisher’s reference to “dominant opinion in the financial community”. The way in which expert analysts’ opinions are shaped by the prevailing consensus view was brought home to me in 1982. It was in the early days of my investing career. In the fall of 1982 I received an analyst’s report from a reputable firm which recommended short selling a particular stock at about $12. The market environment was decidedly bearish as stocks had been in full retreat for many months. I had never seen a recommendation to short sell a stock and I found it noteworthy that this was being recommended. The stock went down to about $11 in the next few weeks and then began a steady climb. Within a year it had topped $30. I have remembered that incident as a good example of how stock market professionals are perfectly susceptible to being caught up in the market mood of the moment.

Peter Lynch remembers that same stressful time: “There was a 16-month recession between July, 1981 and November, 1982. Actually this was the scariest time in my memory. Sensible professionals wondered if they should take up hunting and fishing, because soon we’d all be living in the woods, gathering acorns. This was a period when we had 14 percent unemployment, 15 percent inflation, and a 20-percent prime rate, but I never got a phone call saying any of that was going to happen, either. After the fact a lot of people stood up to announce they’d been expecting it, but nobody mentioned it to me before the fact. Then at the moment of greatest pessimism, when eight out of ten investors would have sworn we were heading into the 1930s, the stock market rebounded with a vengeance, and suddenly all was right with the world.” (Lynch, 1989,1990)p.75.

You did not misread and it was not a typo. There really was 14 percent unemployment, 15 percent inflation and a 20 percent prime rate. The world was going to hell in an handbasket. It was a great time to buy stocks.

The stock analyst whose report I had read in that time of great pessimism was caught up in the pessimistic mood. It was a cheap lesson for me as I didn’t sell anything short at the time.

In light of the fact that many of the biases identified by Kahneman can be mitigated through learning and experience it is remarkable that so many of the supposed pro’s on Wall Street are still prone to make the full range of cognitive errors and are prone to behavioral biases.

Perhaps this is because they are under so much pressure: peer pressure, short term performance pressure from clients and bosses alike and fully exposed to Groupthink. Investment industry professionals are in constant touch with each other. The thundering herd may be a herd of lemmings.

Perhaps they are like everyone else, prone to forget lessons learned. And they also seem to suffer from the Optimistic Bias, at least in normal to boom times. And in a bust they get caught in the general mood of pessimism.

And finally, it may be that they are not as expert as they would like to believe. For many in the industry their expertise is in accumulating assets under management or advisory accounts, or selling ETFs, funds, stocks and bonds rather than in investing in the common shares of real businesses . This latter difficulty is a classic example of an agency problem.

After referring to the exceptional investment records of the likes of John Templeton, George Soros and Warren Buffett, Lynch writes: “These notable exceptions are entirely outnumbered by the run-of-the-mill fund managers, dull fund managers, comatose fund managers, sycophantic fund managers, timid fund managers, plus other assorted camp followers, fuddy-duddies, and copycats hemmed in by the rules. You have to understand the minds of the people in our business. We all read the same newspapers and magazines and listen to the same economists. We’re a very homogeneous lot, quite frankly.” (Lynch, 1989,1990)p.40

Conventional advice

As experts, investment advisors are likely to be the source of very conventional advice. As John Maynard Keynes put it succinctly in The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes, 1936,2007)p.158.

The distinction between conservative and conventional is explained by Warren Buffett in one of his letters to his investors in the 1960s. Buffett commented on the failure of the average mutual fund to outperform the indexes. As reported by Roger Lowenstein: “Why was it, [Buffett] wondered, that “the high priests of Wall Street,” with their brains, training, and high pay, couldn’t top a portfolio managed by no brains at all? He found the culprit in the tendency of managers to confuse a conservative (i.e., reasonably priced) portfolio with one that was merely conventional.”

Lowenstein elaborates, “It was a subtle distinction, and bears reflection. The common approach on owning a bag full of popular stocks – AT&T, General Electric, IBM, and so forth – regardless of price, qualified as the latter, but surely not as the former. Buffett blamed the committee process and group-think that was prevalent on Wall Street.”

Quoting Buffett, “My perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size…” (Lowenstein, 1995,2008)p.85.

For readers wanting to dig deeper into this subject, take a look at Part 2: Human Foibles and Investment Decision Making

In particular, see Chapter 19. Our Urge to Do what Everyone Else is Doing

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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