By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: February 20, 2012
It is no secret that many of the world’s best investors are contrarians who are known for their ability to think independently and avoid the unpleasant results of following the herd. Although the downside of following popular opinion is well documented, it is only recently that researchers have begun to understand why it so difficult for most people to go against the crowd.
According to traditional economics, investors are rational creatures that make logical decisions regardless of non-economic, external factors. In reality, however, many investors do not behave rationally and frequently fall victim to a herd mentality. Behavioral economics blends psychology and economics to explain the forces that can lead to irrational decisions and suboptimal outcomes. Without a good understanding of behavioral finance you can be your own worst enemy when it comes to investing.
Do you consider yourself to be an independent thinker? Would your opinion be affected by what the herd thinks? Which of the following letters on the right most closely matches the letter on the left?
This is not a trick question, one of the letters on the right is clearly too big and one is too small. Would you stick by your answer if you were in a group of 10 and the nine others picked the smallest letter as the best match? There is evidence that, when confronted with a contrary group opinion, people find it very difficult to remain independent.
Group Think and Its Effects
The effects of group opinion have been studied since the 1950s, with a typical experiment involving a question similar to the one above that is presented to a group of eight people. You would be one of eight participants, but unbeknownst to you the other members of your group all work for the experimenter and follow a script giving incorrect answers. You are always the last to answer. How likely is it that your answer would change in order to conform to the majority? Psychologists found that subjects will conform to an incorrect, popular choice approximately a third of the time. Three-quarters of the subjects conformed during at least one round of the experiment, and one-third of the subjects conformed more often than not. It was also found that group size does not affect the rate of conformity once at least three people have answered incorrectly. Moreover, remember that a herd mentality does not require a large number of people, and small groups can affect your thinking just as much as large herds.
The Neuroscience Behind Conformity
Recently neuroscientists have advanced our understanding of what actually happens in our minds when we change our judgment in order conform to incorrect group opinions. One notable study involved 3-D images where two images are shown and the participants are asked if the second image was a rotation of the first. When this test was performed by itself the participants performed very well, correctly answering 90 percent of the questions. When participants could see the answers given by other people in the group, however, only 59 percent of questions were answered correctly — a rate that it is statistically equivalent to flipping a coin to make the decision. Brain scans were performed on subjects during the game, and researchers found that when the group’s answer was chosen there was a decrease in activity in the parts of the brain that are associated with logical thinking. Following the herd is an easy way to stop thinking.
Even more interesting is that when a participant’s answer conflicted with the group, the part of the brain that processes emotion and fear, the amygdala, became very active. Fear reflexes result from not conforming; and while these reflexes may be socially advantageous in a small group, evolutionary context, the opposite is true for investors.
Going against the crowd emotionally disturbs people, and it can also cause pain. Brain scans were performed in a study where a participant plays a three way game with two other players; but, unbeknownst to the participant, the other players were controlled by computers. During the game the computer-controlled players would exclude the participant and then continue to play against each other. This exclusion resulted in activity in the anterior cingulated cortex and the insula, which are the areas of the brain associated with actual physical pain.1 Going against the crowd has the potential to be emotionally disturbing and painful.
Focus on Process, Not Peer Pressure
So what can you do to combat the urge to conform to popular investment ideas? You can try to tune out the herd mentality by focusing on a process that emphasizes fundamental analysis instead of popular opinions. By focusing on a well defined, logical process you help minimize the effect that popular opinion will have on your investment decisions. Regardless, following popular opinion is a good example of non-analytic, intuitive thinking that is not a good basis for making the kind of tough decisions that result in superior returns.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif. David serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.
1 James Montier, The Little Book of Behavioral Investing (John Wiley & Sons, Ltd., 2010), 161-172