As US markets raced higher in January, ordinary investors were going gaga for stocks. There were four times as many bulls as bears, according to an American Association of Individual Investors (AAII) poll, one of the biggest differentials in the survey’s three-decade history. Then, stock markets plunged, and minds were quickly changed: today, AAII polls show there are more bears than bulls.
Mass conformity in fund managers is easily explained by career risk. Someone who bets against the crowd and gets the timing wrong might end up losing their job. However, ordinary investors don’t face such pressures, so why are we so easily swayed by the madness of crowds? Is it really that difficult to go against the herd?
In a nutshell, yes, it is that difficult. “How the Opinion of Others Affects Our Valuation of Objects”, a 2010 study published in the Current Biology journal, found that the opinions of others “can easily affect how much we value things”. The value you place on something is likely to increase when others tell you it is worth more than you thought, the researchers found, and decrease when others say it is worth less.
Bitcoin comes to mind in this respect. A Twitter poll conducted last year by Pension Partners' Charlie Bilello revealed that more than half of respondents believed bitcoin was in a bubble when it was trading at $2,200. A few months later, bitcoin had more than doubled and was trading at $5,300, but fewer people now believed they were witnessing a bubble while more than twice as many people saw it as undervalued. The more popular bitcoin became, the more people believed in it.
Experiments
Serious investment thinkers like Nobel economist Robert Shiller and behavioural finance expert Michael Maboussin have long argued investors are all too vulnerable to social pressures.
"Humans are social and generally want to be part of the crowd," wrote Mauboussin in a 2015 Credit Suisse note which referenced the famous conformity experiments conducted by psychologist Solomon Asch in the 1950s.
The experiments involved easy questions with obvious answers, such as asking people whether two particular lines were the same length. However, Asch rigged the experiment so that a number of actors would deliberately give the wrong answers. When people heard these incorrect answers, they conformed to the majority’s wrong opinion more than one-third of the time. Three-quarters of people ignored what they could see with their own eyes and answered incorrectly at least once; only one in four consistently stuck to their guns.
The importance of individual suggestibility and group pressure is also stressed by Shiller, who has written about another classic psychological experiment where participants were seated in a darkened room and asked to view a point of light seen through a small hole in a metal box. Participants were told the point of light would begin to move and asked to report the magnitude, in inches, of its movements. In reality, the point was not actually moving. However, when placed in groups so that they could hear the answers of others, people arrived at a consensus on the amount of movement. Afterwards, they showed little awareness of the influence of the group on their individual decision.
Brain scans
Today, brain scans help explain why people so readily succumb to conformity. Firstly, it feels good to conform. In the aforementioned Current Biology study, the researchers noted that when people discover that someone else agrees with them, it activates reward centres in the brain. Essentially, if someone with agrees with you, it’s intrinsically rewarding in the same way that food, sex and money are rewarding.
Secondly, Mauboussin notes separate studies showing people who make independent choices show increased activity in the amygdala, the brain region that is associated with anxiety. Not conforming “creates an emotional burden”, says Mauboussin, “and requires overcoming a wave of fear”.
The same point is made by GMO strategist and author James Montier in The Little Book of Behavioral Investing. Social exclusion, writes Montier, activates areas of the brain associated with physical pain. "Doing something different from the crowd is the investment equivalent of seeking out social pain," adds Montier. Following contrarian strategies "is really like having your arm broken on a regular basis – not fun!"
Financial advisers and money managers often highlight what they have to offer in this regard, stressing their awareness of these financial blind spots can help ordinary investors to ignore the herd when it is advisable to do so. However, it may not be so simple. After all, the literature shows the desire to conform, to run with the herd, is not confined to undisciplined or intellectually weaker people. Rather, it is a very human thing, and the best advisers are likely to find it emotionally challenging to resist the lure of the crowd.
That is confirmed by a 2015 survey conducted by the CFA Institute, a global association of investment professionals, which asked its members to select the behavioural bias that most affected their investment decisions. Herding – being influenced by peers to follow trends – was easily the most common bias.
Shiller’s discomfort
Indeed, Robert Shiller, who has spent a lifetime documenting the madness of crowds and the dangers of market bubbles, admits to finding it similarly difficult to fight the group consensus. Although Shiller warned on multiple occasions prior to the outbreak of the global financial crisis that the US housing market was a bubble that was in danger of bursting, he admitted in 2008 he “feared criticism for gratuitous alarmism”.
As an adviser to the Federal Reserve Bank of New York between 1990 and 2004, he “felt the need to use restraint”, to make his point “very gently”. The consensus was there was no bubble and to suggest otherwise was “distinctly uncomfortable”. Shiller “felt vulnerable expressing such quirky views”, adding: “Deviating too far from consensus leaves one feeling potentially ostracised from the group, with the risk that one may be terminated.”
"If you have formed a conclusion from the facts and if you know your judgment is sound, act on it even though others may hesitate or differ," wrote legendary investor and author Benjamin Graham. "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." No reasonable person would disagree, but it's not easy to act on Graham's advice.
Conformity feels good; going your own way breeds anxiety and discomfort, as Shiller will testify. And if Shiller – a celebrated Nobel economist lauded for his insights into financial bubbles and mob behaviour – feels uncomfortable fighting the investment crowd, you and I are unlikely to be any different.
