Investor Psychology

Don’t Trust the Crowd

The herd, it seems, alters our perception of reality.

Back when I was a newspaper editor in Rochester, N.Y., an investment club invited me to speak about small-company stocks, a subject I occasionally wrote about. Before the session, I talked with club members to learn more about how they picked stocks. They explained that they focused on a single strategy involving small companies and earnings momentum. So fixated were they on this one approach that when I asked whether they employed other strategies as well, it was as if I had asked members of the Southern Baptist Convention who else they worshiped besides Jesus.

At one point during the session, I tried to point out that small growth companies represent just a thin slice of the market -- and a risky one at that -- and recommended that the group consider diversifying. I might as well have told the aforementioned Baptists they should also consider that Buddha fellow.

I felt uncomfortable at the meeting, and I puzzled over my reaction and the group’s reaction to my advice. But knowing what I know now, it all makes sense. Those investors had succumbed to a well-documented pitfall: herd mentality, a phenomenon in which people seem to abandon reason and simply follow the crowd.

In the case of investment clubs, the results of groupthink are striking. A study by Brad Barber and Terrance Odean, professors at the University of California, showed that portfolio results of investment clubs lagged Standard & Poor’s 500-stock index by 3.7 percentage points per year.

And investment clubs aren’t the only victims of herding. Having profiled many mutual fund companies, I know that some of them fanatically follow their own myopic strategies right off a cliff.

What’s scary about the herd mentality is how insidiously it gets you to see things differently. In fact, a recent experiment showed that we may actually be hard-wired to believe what the crowd tells us. In the ex-periment, conducted at Emory University, participants were asked to look at an object (an assemblage of cubes) and then judge how it would look if it were rotated slightly. But there was a twist: Other participants -- who in reality were actors hired for the experiment -- were instructed to give wrong answers in an attempt to sway the opinions of their fellow participants. Sure enough, the real subjects, influenced by the actors, gave incorrect responses, despite what their own eyes told them.

Brain scans found that participants didn’t just decide to go along with the crowd. Instead, the crowd’s opinion actually changed their perception of the problem. Participants “saw” the objects differently. The herd, it seems, alters our perception of reality.

The experiment involved thinking independently about a simple problem, says Gregory Berns, a professor of psychiatry and economics at Emory University and one of the study’s authors. Thinking independently about investing is more difficult, says Berns, because valuing stocks, for example, is “a slippery perception that can be pushed around by all kinds of forces.”

Berns’s experiment also explains why I felt so uncomfortable talking to that investment club. Brain scans performed as part of the study showed that disagreeing with a group stimulates pain centers of the brain.

So how do you resist being co-opted by the madness of crowds? It’s not easy, admits Berns, author of Iconoclast: A Neuroscientist Reveals How to Think Differently (Harvard Business Press, $30). The first step is to be aware of how easily we’re influenced. That may make you feel like an outlier, but it can also be “very liberating,” says Berns.

Then you can concentrate on the smartest investing strategy: spreading your risk across many types of investments and periodically redistributing your money among them.

Kiplinger’s is partnering with Nightly Business Report on the “Your Mind & Your Money” series, funding for which is provided by the FINRA Investor Education Foundation. For companion video reports, tune in to NBR on your local PBS channel Nov. 16 and 30.

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