Behavioural finance: monkey see, monkey do?

The urge to do as others do is a powerful force on our investment decision-making, yet most of us are barely aware of it, according to Fidelity's Tom Stevenson.

Conforming to the group or to societal norms is a critical part of what it means to be human; a primitive instinct, deep-rooted in our brains, which primes us to stay in the safety of the herd.

Because there is comfort to be found in the herd, we are often guilty of rationalising away our sheep-like behaviour.

Experiments show that we actually feel better when we are in the herd and not out on a limb on our own.

But in investment there is also danger in conformity because herding in investment markets can push up the values of certain investment sectors or stocks to extreme levels, causing bubbles that invariably end badly.

The urge to conform is incredibly powerful. To demonstrate the point, psychology pioneer Solomon Asch carried out a range of revealing conformity experiments in the 1950s which are still widely discussed today.

His experiments showed that people are actually willing to make basic cognitive errors in order to go with the flow.*

Asch placed individual participants in groups where all the others (called ‘confederates’) were in on the experiment.

The task was to judge the length of a vertical line against three comparison lines and say which was equal in length to the original.

The genuine participants were asked last within the group. After a couple of rounds where the confederates answered correctly, they deliberately answered incorrectly to apply group pressure to the participant.

In total, about one third of the subjects who were placed in this situation went along with the incorrect majority. Incredibly, 75 per cent of the genuine participants conformed to the wrong answer at least once.

Fortunately, Asch not only discovered that many people slip into conformity easily, he also revealed it doesn’t take much to snap them out of it.

In later experiments, Asch planted a rational rebel in the crowd who went against the group when they were incorrect.

Critically, having just one right-thinking person contravene the group made the genuine participants eager to express their true thoughts and also take a stand.

This is an important finding for any decision-making group and the reason that some chief executives give their opinion last.

If they didn’t there would be a real danger that everyone would simply agree with their view if stated at the outset.

The advantage of speaking early is hugely influential because first impressions really do count.

Consider these two individuals:

• Alan: Intelligent, industrious, impulsive, critical, stubborn, envious.
• Ben: Envious, stubborn, critical, impulsive, industrious, intelligent.

Chances are you viewed Alan more favourably than Ben, because the initial positive traits affect the way you think about his latter traits.

His impulsiveness is more than compensated for by his intelligence.

The reverse is true of Ben – he is envious and stubborn and intelligence only serves to make him more dangerous.

This is the “halo effect” – our impressions of people and things can be strongly influenced by our initial or overall sense of them.

Investments can have a halo effect too – if they performed well for a time when we first bought them, we may be inclined to view them favourably even though conditions may have changed and we might now be better off in an alternative.

Asch proved that playing devil’s advocate has real psychological backing.

When it comes to investing, investors should make the time to analyse their decisions and explore the opposite view to their own, particularly if they find they are acting in a consensual way common to many other investors.

This conscious and deliberate attempt to be contrary and go against the herd can be highly effective in investment.

While the crowd is often right in momentum-driven markets, there are countless examples of the herd being wrong-footed at market turning points.

The widespread dash into technology stocks in the late 1990s was a classic case of herding behaviour. The more extreme valuations became, the more the crowd was trying hard to make different-sized vertical lines look the same height.

The market was making a collective cognitive error in its overly optimistic assessment of prospects for dot.com stocks, many of which had achieved very little.

Cynics went against the flow, re-examining the value of these shares using tried and tested fundamental measures based on actual earnings, eschewing an array of fanciful new valuation measures such as “eyeballs per page”.

Of course, taking the contrary view proved to be highly successful.

Identifying bubbles is straightforward in retrospect, but a little more challenging at the time when investing emotions are running high.

The economic historian Charles Kindleberger helpfully identified five discrete phases of a bubble.

Stage one is displacement, where the introduction of a new technology (such as railways or the internet) or growth dynamic takes hold.

This is often when the “smart money” gets in.

Stage two is the boom, when a highly persuasive narrative takes hold (e.g, “the internet will change everything”). This phase is often accompanied by access to cheap credit.

Stage three is euphoria where the boom becomes over-extended; new investors are sucked in with the lure of easy gains but often little understanding of the risks. The rational underpinnings of the boom are now stretched.

Stage four is crisis where insiders begin to sell, and prices fall back precipitously.

Stage five is revulsion where investors capitulate and prices tend to overshoot on the way down.

This phase is often accompanied by the kind of political backlash and suggestions for regulatory reform that we have seen in the wake of the credit crunch.

There are some practical steps investors can consider to reduce their exposure to stock market bubbles. For instance, there is some persuasive evidence that stock market capitalisation indices tend to over-reflect the thinking of the herd.

This is because their reliance on price means that they systematically give higher weight to glamorous, overvalued stocks.

Hot sectors take a higher weight in the index as they grow, making subsequent reversals in those sectors more painful.

For instance, in 1996, the IT sector accounted for around 10 per cent of the overall market cap of the S&P500 Index.

By 2000, it had trebled to a massive 33 per cent, making an investment in the S&P500 a fairly concentrated bet on US technology.

The subsequent correction saw this figure fall back to 14 per cent by the mid-2002.

Investing actively and strategically to avoid such concentrations when risks begin to outweigh rewards is critical.

Yet, the issue with market capitalisation indices also raises some questions about the value of benchmarking.

This is why many fund providers and investors are increasingly moving towards the unconstrained funds, which are managed without reference to a benchmark.

Unconstrained funds can offer a genuinely different approach to investors.

Releasing the portfolio manager from the straitjacket of the benchmark removes the obstacles to them investing in their ‘best ideas’ based on an absolute assessment of the risks and rewards.

An unconstrained approach can be seen as a deliberate attempt to move away from the index-tracking herd.

As Sir Jon Templeton – one of the greatest investors of the twentieth century – said:  “It is impossible to produce a superior performance unless you do something different from the majority”.

* Source: Asch, S. 1958. Effects of group pressure on the modification and distortion.

Tom Stevenson is the investment director at Fidelity Worldwide Investment.