Investing Psychology Chapter 4: The Danger of Groupthink (Part 1)
Humans are social animals. We evolved to survive in groups, and that means we have a deep-seated need to fit in. But in Chapter 4, Tim Richards explains that while “conforming” kept our ancestors alive, it’s making modern investors broke.
Conform or Die
Solomon Asch ran a famous experiment where a group of people had to compare the lengths of lines. Everyone except one person was “in” on the trick. They all chose the obviously wrong answer.
Guess what? 75% of the real participants chose the wrong answer too, just to fit in with the group. They didn’t trust their own eyes because they didn’t want to be the “odd one out.” In investing, if you’re always doing what everyone else is doing, you’re guaranteed to get average (or below average) results.
Mutually Assured Delusion
When a group gets together, they start to suffer from groupthink. This happened with the NASA management before the Space Shuttle disasters. They ignored clear warnings because the group had already decided everything was fine.
In the market, this is “Mutually Assured Delusion.” Groups of investors will ignore bad news and egg each other on until they’re all over a cliff. If you want to test this, go to an investment forum and point out a flaw in the “hottest” stock. Watch how fast they attack you.
We Feel Before We Think
We like to think we’re logical, but the truth is we feel an opinion first and then look for facts to support it. This is motivated reasoning.
It’s hard to “unbelieve” something once it’s in your head. This is why you should never invest under time pressure or while you’re emotional. You’ll literally forget to look for the reasons why you might be wrong.
The Risky Shift
Groups don’t tend toward the average; they tend toward the extreme. This is called group polarization or a “risky shift.” A group of investors will talk each other into taking much bigger risks than any of them would take alone.
Your Personal Mission Statement
The best way to fight social pressure is to have your own manifesto. I have one, and you should too. It should be a simple rule like: “I buy high-quality companies when they are undervalued and hold them until they are overvalued.”
When your neighbor starts bragging about a “surefire” crypto coin, look at your mission statement. Does it fit? If not, ignore the noise.
In the next post, we’ll talk about how “framing” changes your decisions and why your neighbor’s new car is making you unhappy.