Investment psychology
The urge to do what everyone else is doing
Everybody knows about this problem, so what is there to learn? Most readers will have read articles about behavioral psychology and have a general level of understanding. And that’s the danger. As they say, a little knowledge is a dangerous thing.
So, how do we get beyond the danger point? Let’s turn this around. I’ll set out what Daniel Kahneman would call the ‘risk policies’, a concept I discussed last week, see here. After that I’ll take you through what you need to know to truly internalize the ‘risk policies’.
Let me make a point at the outset. I believe that a proper understanding of and the ability to deal with our human psychological foibles is the key difference between being a poor investor and achieving superior performance.
What I call gap-to-edge rules are policies designed to free us from urge to do what everyone else is doing. By gap-to-edge I mean, free yourself from the behavioral gap and develop a behavioral edge over Mr. Market. These are Kahneman’s ‘risk policies’.
Gap-to-edge rule: When all is going well in the stock market, be wary. When all is going badly, take heart from the opportunities that present themselves.
Be reminded of four of John Templeton’s Maxims.
Maxim 3. It is impossible to produce a superior performance unless you do something different from the majority.
Maxim 4. The time of maximum pessimism is the best time to buy. And vice versa. Buy when published predictions reflect an unusual level of gloom and sell when the consensus is unusually optimistic. This applies to share prices generally and also for particular industries.
Maxim 5. To put “Maxim 4” in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.
Maxim 6. To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
Gap-to-edge rule: Do not to be contrary just to be contrary. We must be prepared to be contrary when our independent judgment tells us to be. Sometimes the crowd is right.
Gap-to-edge rule: Maintain some physical and mental distance from Wall Street.
It may be no coincidence that two the most successful investors of the last one hundred years lived and worked a long way from Wall Street. Both Warren Buffett, who has lived and worked in Omaha, Nebraska, and John Templeton, who lived and worked in Lyford Cay in the Bahamas, kept their distance.
John Templeton’s walks along the beach or sitting and watching the sea may have been one of his personal gap-to-edge rules. Today it might be called a habit of deliberate mindfulness. In a connected world, getting away from the phones allows you to disconnect. This is surely not a bad thing with all the pressures and problems of herding.
Gap-to-edge rule: Take nothing on faith from experts.
Analysts and other experts have many fine ideas and opinions. They also have many bad ideas, suffer from biases and make errors. Every recommendation should be supported by simple empirical evidence that a person of average intelligence can understand.
Gap-to-edge rule: Develop and hold a strong sense of intrinsic value. Reframing from price to value is one of the most important ‘risk policies’ in the successful investor’s tool kit.
Gap-to-edge rule: Remember that when things seem too good to be true, they usually are.
Gap-to-edge rule: Don’t be afraid to be out of step with everyone else
Herding
So, what is herding and how strong is the urge? We know we have the capacity for independent thought. But, it seems Humans are all too affected by the views of others. The issue comes up in many contexts. At the most extreme is the madness of crowds and mobs. Such madness is a real pathological human trait. Herd and lemming-like behavior are also fairly extreme.
More subtle are peer and career pressures. More subtle again and still very powerful is group thinking (Groupthink).
And then there are the forces that cause us to do what others are doing because we believe that what everyone else is doing must be right. This has been called ‘social proofing’.
Herding and groupthink
Elsewhere in the Motherlode, we have looked at Kahneman’s heuristic which Humans use to answer difficult questions or make difficult judgments. See here. This alternative to careful reasoning may cause us to answer the question of what is the fair value of a stock by asking the question, what is the ‘market value’? Which is, in effect, erroneously asking other investors what they think the fair value is. The answer they get is ‘price’ not ‘value’.
I hate the expression ‘market value’. The market does not determine value.
Gerald Loeb astutely observed: “Even the price of a stock at a given moment is a potential influence in fixing its subsequent market value [sic]. Thus a low figure might frighten holders into selling, deter prospective purchasers, or attract bargain seekers. A high figure has equally varying effects on subsequent quotations.” (Loeb, 1935, 2007)p.2.
Shiller points out that: “the popular notion that the level of market prices is the outcome of a sort of vote by all investors about the true value of the market is just plain wrong. Hardly anyone is really voting. Instead people are rationally choosing not to, as they see it, waste their time and effort in exercising their judgment about the market, and thus choosing not to exert any independent impact on the market.” (Shiller, 2005 Second Edition)p.160.
The investing crowd is not assembled in a gigantic meeting hall. There is no committee meeting and verbal sharing of views. Nevertheless, a kind of Groupthink occurs.
Anchoring and priming
We need to consider the impact of observed prices on investors’ thinking. One mechanism at work is what Daniel Kahneman calls Anchoring and Priming.
As to Anchoring, Kahneman writes: “This is a very common effect. It occurs when people consider a particular value for an unknown quantity before estimating that quantity. What happens is one of the most reliable and robust results of experimental psychology: the estimates stay close to the number that people considered – hence the image of an anchor. If you are asked whether Gandhi was more than 114 years old when he died you will end up with a much higher estimate of his age at death than you would if the anchoring question referred to death at 25. If you consider how much you should pay for a house, you will be influenced by the asking price.” (Kahneman, 2011)p.119.
The way anchoring works is through suggestion. Kahneman writes: “… suggestion is a priming effect, which selectively evokes compatible evidence.” (Kahneman, 2011)p.122.
The simple fact is that prices in the stock market act as anchors or primes on buyers.
Kahneman writes: “Many psychological phenomena can be demonstrated experimentally, but few can actually be measured. The effect of anchors is an exception. Anchoring can be measured, and it is an impressively large effect.” (Kahneman, 2011)p.123.
So let’s face it, in our investing, when we consider the intrinsic value of a stock, the market price acts as a prime and as an anchor. As well, sell side analyst reports set out targets that also act on our brains as anchors or primes.
As Kahneman writes: “The main moral of priming research is that our thoughts and our behavior are influenced, much more that we know or want, by the environment of the moment. Many people find the priming results unbelievable, because they do not correspond to subjective experience. Many others find the results upsetting, because they threaten the subjective sense of agency and autonomy.”
Weird result
The result is that something very weird happens. According to classical economics and the rational utility-maximizing Econs, when prices go up, people will buy less. In the real investing world of Humans people often buy more when prices go up. So much for efficient markets.
I have tried to give the reader a deep enough explanation that you will realize how forceful, dangerous and ubiquitous herd and crowd thinking can be. Hopefully the gap-to-edge rules will help shield you from their effect.
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
Readers wishing to read deeper into this subject can start with Chapter 19. Our Urge to Do what Everyone Else is Doing
And particularly Sections:
19.01 Crowd mentality is nothing new
19.02 The others can’t be wrong!
19.05 Answering an easier question
19.07 Psychological anchors for the market as a whole
19.08 Experts and authorities are susceptible to Groupthink
19.10 Gap-to-edge rules for this chapter
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction
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