How groupthink can derail your investment plan

By Larissa Fernand |  20-01-20 | 

I often think of the words of neurosurgeon Wilfred Trotter: "Society teaches us from childhood that it pays to be part of the group and not be too different." His book on social psychology Instincts of the Herd in Peace and War is a classic.

Psychologist Irving Janis, author of Groupthink, introduced the term in 1972 to that refers to a psychological phenomenon or a mode of thinking in which people strive for consensus within a group. In many cases, people will set aside their own personal beliefs or adopt the opinion of the rest of the group. To blend in, they will refuse to realistically appraise alternative courses of action. Groupthink results in a deterioration of mental efficiency, reality testing, and moral judgement.

Groupthink is a well-documented human bias that has implications for investing too. For instance, members of an investment committee might suffer from the same tendency and be eager to agree and reluctant to disagree with their peers, even when they have ample reason to. Janis believed groups of intelligent people sometimes make poor decisions because groups prevent contrary information from being given the proper level of due diligence.

Michael Pompian expresses his view on groupthink in investing.

In mid-2016, prevailing wisdom said two things: central banks will continue to intervene in the global markets, and economic growth will be anemic.

Economic forecasts from Consensus Economics in mid-2016 noted that the average prediction was for the U.S. to expand 2.4% in 2017--the lowest rate since 2012. Furthermore, economists were in near-complete agreement on this forecast.

As a result, high-quality, long-dated government bonds remained at historically low yields. In the stock market, "safe" stocks, such as minimum volatility stocks, traded at their highest valuation premiums to the wider global market since 2002, measured by price-to-book, price-to-cash earnings, and price-to-forward earnings. The demand for quality and consistency of earnings, together with the desire for stable dividends, drove companies such as Coca-Cola, General Mills, and Johnson & Johnson to new highs.

This is an example of classic groupthink in action. In the linked Wall Street Journal article, the author notes that: Two things most of us think we know for a fact, after years of extraordinary central-bank intervention and miserable growth, are that we will have more extraordinary central-bank intervention and more miserable growth.

These stocks and bonds became very expensive because the majority of market participants agreed on a single consensus: continued intervention by global banks and anemic global economic growth.

As we know, the bubble in minimum volatility stocks popped.

In the midst of groupthink, the challenge is having the conviction to know you are right even if it goes against the crowd, and the courage to take action in your portfolio. That's what being a contrarian is about.

Sir John Templeton was famous for saying that the best time to buy stocks is "when there's blood in the streets."

Howard Marks from Oaktree constantly reminds us in his letters that human nature compels investors to "buy high and sell low," and his advice is to do just the opposite.

When groupthink dominates and valuations reach extremes, it's probably time to take the opposite side of the trade.

In How to avoid groupthink, behavioural finance coach Paul Craven addresses the problem.

He suggests three measures — creating an environment where people can disagree, ensuring the devil’s advocate role is an integral part of the decision-making process, and recording the rationale behind decisions once they are made — to manage behavioural biases in investment decisions.

  • When it comes to an investment committee, Craven feels that the chair of the committee has a key role to play in tackling the issue.

The chair can create an environment where people are not dissuaded from voicing dissent and are encouraged to play the devil’s advocate. He suggests that the investment committee can be smart and formal about how it uses a devil’s advocate. A member of the committee could be assigned the task of researching an issue and coming in prepared to argue the other side of what is being proposed.

Craven gave the example of 12 Angry Men, a classic drama, in which one dissenting member of a 12-man jury successfully plays the devil’s advocate, resisting and challenging the consensus of his 11 colleagues until they are all won over.

  • Fight it out in your mind

When it comes to our personal investing issues, Craven clarified that we can play the devil’s advocate in our own minds, questioning our views and arguments, rather than assuming our reasoning is always sound. To paraphrase John Maynard Keynes, we should be willing to change our minds when the facts change.

  • Document your arguments

Alternatively, we can keep a journal of key decisions and recording the rationales behind them instead of relying on memory. A recorded journal allows you to revisit your reasoning on a particular investment decision and will keep you from forgetting and rewriting the past in your mind as time progresses. “Memory is a very bad teacher,” cautioned Craven, and you may not be able to accurately recall why you made a certain decision at a certain time. By going back to the recorded logic behind the decision, an investment committee can judge if it was suffering from groupthink or demonstrated an openness to alternative views.

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