Imagine you are travelling to a new city. After the whole day of sightseeing, one of the most important decisions you need to make is which restaurant to dine in. You narrow it down to two restaurants located next to each other, which are quite similar in terms of cuisine and prices. One of them is empty and the other is crowded. Which one would you choose to dine in?

While making a decision, most of us love the comfort of the crowd. We trust the wisdom of a large group to choose the right restaurant, movie, music or phone. And most of the time, this herd instinct or herding works well for us. Herd instinct is a mentality that is distinguished by a lack of individual decision-making, causing people to think and behave in a similar fashion to those around them. Unfortunately, this behavioural bias has some serious consequences in the investing world.

One of the essential conditions of a well-functioning market is diversity of views. Investors making unbiased assessments of the securities and acting independently cause efficient price discovery. This is because, even if their individual thinking is faulty, the mistakes would cancel each other out. This diversity is lost when investors follow what they perceive other investors are doing, rather than depending on their own analysis. In other words, an investor exhibiting herd instinct will gravitate towards the same or similar investments based almost solely on the fact that many others are buying the securities. Herd instinct has a history of starting large, unfounded market rallies and sell-offs that often lack fundamental support to justify either. Over time, this has been a significant driver of asset bubbles in the financial markets.

SOLOMON ASCH EXPERIMENT

Solomon Asch, a Polish-American psychologist, conducted experiments to understand the degree to which a person’s own opinions are influenced by those of groups. In one of the experiments, participants were called in groups of eight and shown two cards. One card had one straight line which had to be matched with the three lines shown in the other cards. Each participant was supposed to call out the answer in terms of A, B or C. Asch designed the group in such a way that there was only one test subject in the group, the others were confederates who were told to answer in a particular pattern. There were 18 trials and the confederates were asked to answer 12 of them incorrectly.

About 75% of the actual test subjects (excluding confederates) went with the majority at least once and 32% of the test subjects went with the opinion of the majority all the time. Privately, these subjects were able to give the correct answers, but they preferred to conform to the crowd during tests. Asch’s experiments are important in understanding that people feel the need to fit into the group. In subsequent experiments, Asch was also able to prove that conformity increases if the group is large; conformity increases when the subject is faced with higher uncertainty (difficult task); and conformity also increases when members of the group are of a higher status.

All these observations are extremely important to stock market investing. The crowd is obviously much larger, and the media also contributes to providing a high-pitched broadcast of popular ideas. Intrinsic values of companies are uncertain and don’t have a definite mathematical formula. Hence, it is a difficult task to estimate fundamental valuations of companies. The influence of experts (who are also vulnerable to herding) is also strong on individual investor’s opinion.

CONTRARIAN THINKING DIFFICULT BUT NEEDED

It is tempting to be part of the crowd and indeed, painful to avoid the herd instinct. Contrarian investing (going against the crowd) is more about the emotional strength (behavioural edge) than knowledge (information edge). Neurologists have found that the parts of the brain that respond to exclusion were the same parts that responded to physical pain. In other words, the feeling of being excluded or rejected provokes the same sort of reaction in the brain that physical pain might cause. Standing against the crowd is, hence, extremely painful.

However, for successful investing, contrarian thinking is important. Swaying with the pendulum of market mood can compel the investor to buy during a bubble and sell during a crash. To take advantage of these market swings, an investor needs to design a good investment philosophy and process and follow it with discipline to generate superior returns compared to the crowd.

It is equally important to have the right team or right set of people to discuss investment ideas with. In the experiment, Asch found that having one of the confederates give the correct answer, while the rest of the confederates gave the incorrect answer, dramatically lowered the conformity of the test subject. It shows that most investors can improve their decision-making with the right support.

Nimesh Chandan is head of equities, Canara Robeco Mutual Fund

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