“Never, ever listen to other opinions.

To succeed in the markets, it is essential to make your own decisions. Numerous traders cited listening to others as their worst blunder. Walton and Minervini lost their entire investment stake because of this misjudgement.”

—Jack Schwager ¹

Never follow a stock tip. That’s the received wisdom.

But what if it’s a trusted friend with the advice, and she’s an insider of sorts, and she’s extra-specially certain that this stock is about to rocket?

I hadn’t bought a stock on a “tip” for many moons. I’d been preaching to others—“Don’t buy stocks on tips!”—for years.

So I was a hardened cynic when my trusted friend from college (let’s call her “F”) told me she had a great stock tip. F works at a hedge fund in London. She’s a biotech specialist of sorts, and she had the inside juice on Neurocell (not a real name). Neurocell was a small pharmaceutical company seeking U.S. Food and Drug Administration (FDA) approval for a revolutionary new treatment for Alzheimer’s disease. Neurocell had approval for its medication in Europe, and it was awaiting FDA approval in the United States.

Reported F, “They’re gonna get FDA approval any day now—I’ve talked to all the main investigators who studied their drug.”

F told me she had cold-called neurologist and psychiatrist researchers at 12 medical centers where the drug had been tested, and they had been quick to praise the compound.

When I expressed some skepticism and concern that researchers don’t see the long-term side effects data, and they had all been blinded to the real identity of the compound during those trials, she dismissed my concerns with a self-confident wave of her hand.

“I’d buy it for your children’s college fund is what I’d do.”

Wow! Now to me that seemed like a pretty heavy endorsement—I’d be negligent not to wager my children’s college education on this one. I hadn’t seen F get so excited about many things in the past. She was practically obsessed with this company and its product.

I knew that her fund has had great success over the years, with a greater than 20 percent average annual return since 1996. I’d previously met with the founder of the fund. “We don’t buy anything unless we’re sure it’ll jump 30 percent over the next year,” he’d said.

Neurocell was a guaranteed winner, a great company endorsed by a hedge fund with a fantastic track record. It looked like a ‘strong buy’ if I’d ever heard one. I briefly thought, “I shouldn’t buy this stock based on a tip,” but then the certainty of someone who had called 12 medical centers infected me.

I bought a few shares. And then I bought some more shares until I had accumulated, in hindsight, too many. The FDA approval letter was expected any day, and the excitement was building.

But then the FDA rejected Neurocell’s application. Ouch.

The FDA’s letter was pessimistic due to a higher rate of strokes in people who received the drug, but it still had a chance for approval. More data was needed from the company. The FDA rejection caused a 60 percent decline in Neurocell’s stock price within the first week.

My doubts were festering. “Why did I buy this stupid stock?” I asked myself. “I don’t know anything about cardiac catheterization, and now I’ve lost 60 percent!”

I soon realized I was in deeper trouble than I knew.

I heard from F a week after the FDA rejection letter. She sounded very upbeat. She said, “Gosh, work’s been crazy. Neurocell is at such a discount, we’re buying as much as we can get. We bought a ton the first day of the drop.”

“Buying more?” I thought incredulously. Now I’ve done some quantitative research in my time, and the general price pattern after a surprisingly negative news shock is a brief dead-cat bounce, and then more selling. Why had she bought on the first day of the decline? Then I remembered the old saying from business lore, “If you don’t know who the sucker is, then it’s probably you.” Oh. Double-ouch.

Of course, F didn’t tell only me to bet the ranch on Neurocell. She had also endorsed the stock to many of her other friends and family.

Now F was in a bit of a pickle. She had many friends with money lost, and so she was compelled, via the sunk-cost bias (like the endowment effect), to continue cheerleading Neurocell. She had all this social pressure to deliver good news, and she was stuck in the frame of positive analysis. She couldn’t be objective anymore.

If you’ve ever given a stock tip, you’ve probably regretted it. In general. by the time someone gets excited enough about a stock to recommend it to others, much of the good news has been priced in. It probably already appreciated in price, and chances are that other owners feel as enthusiastic as you—not usually a good sign. Plus, when you commit yourself to a stock by declaring it a sure winner to your social group, then for the sake of consistency, your mind will have trouble abandoning that belief.

I sold my Neurocell shares shortly thereafter. I hadn’t had a plan in case of an FDA rejection letter. I had been too ill disciplined to make one. “When in doubt, get out,” as the old Wall Street saying goes. If you let your guard down just a little, Mr. Market will always make you the sucker.

Following stock tips is one type of herding. In finance, herding refers to the collective and contagious influence of investment ideas. When the majority of investors are following a leader’s advice, without doing the necessary due diligence themselves, they are herding.

HERDING

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

—Charles MacKay ²

Biologically speaking, herding refers to the tendency of some species of animals to seek safety in numbers. Herding occurs both when animals feel threatened and when they sense that one of their number has found an opportunity. Sometimes the entire flock startles abruptly into flight. Sometimes they rush simultaneously into the same green pastures.

Investors often confuse herding with other phenomena. Groupthink is the tendency for members of homogenous groups to come to the same (and often wrong) conclusion. “Mob” or “crowd” behavior refers to the contagious quality of sudden actions by someone in a crowd—usually toward panic or violence. Groupthink is a particular problem for investment committees, while an example of crowd behavior is a run on a bank, as in Moscow during the Russian debt default and ruble devaluation in 1998.

Is herding really such a bad thing? It can cost you money if your timing is poor, but if you’re a first mover, it can make you rich. By the time you see the herd stampeding, you may be too late to get out of the way. However, if you identify a greener pasture, you can get there first. When the crowd follows, you will be well positioned.

Leadership is an essential feature of herding. Sheep follow the alpha male. Often, a sheepdog can direct an entire flock by identifying and cajoling the leader alone. This tendency to follow becomes more pronounced when fear (as of a predatory sheepdog) sets in.

In the markets, you can make money by watching the leaders. Where are they focusing their attention? What are they selling off? In publicly traded companies, the leaders are the executives, board members, and other insiders. Often when there is significant insider selling or a secondary offering, trouble follows. Of course, the insiders will never acknowledge the warning. As a savvy investor, it’s your job to scrutinize, not follow, authority.

In 2000, I did some interesting work at a hedge fund in San Francisco. The partners were scouring the United States markets for inexpensive railroad and energy stocks. If you recommended railroad or coal stocks to your golf buddies in 2000, they would have thought you were crazy. Of course, in 2000, the herd was in Internet, technology, and biotech stocks, not in energy. But this fund was prescient. In 2002, the market’s vanguard migrated into railroad and energy stocks. By 2006, such stocks were the darlings of the market. Many of the stocks of the hedge fund I worked for had appreciated tenfold.

It is relatively easy to see investors herding if one watches money flows and media attention. However, it is not easy to identify the next fresh pastures, and it is particularly difficult to prevent oneself from following the herd. Social and peer pressure can be intense.

Within a decision-making body, such as an investment committee or board of directors, herding is very difficult to prevent. Groupthink, deference to authority, and social pressure to agree cause herding among insiders. The presence of authoritative or charismatic leaders often unintentionally stifles dissent. It feels socially unacceptable to contradict a group leader, even when members are encouraged to do so. Identifying the process of herding, preventing it in oneself and one’s groups, and taking advantage of it in the markets, is the theme of this chapter.

SOCIAL PROOF

“Let me tell you the story of the oil prospector who met St. Peter at the Pearly Gates. When told his occupation, St. Peter said, ‘Oh, I’m really sorry. You seem to meet all the tests to get into heaven. But we’ve got a terrible problem. See that pen over there? That’s where we keep the oil prospectors waiting to get into heaven. And it’s filled—we haven’t got room for even one more.’ The oil prospector thought for a minute and said, ‘Would you mind if I just said four words to those folks?’ ‘I can’t see any harm in that,’ said St. Pete. So the old-timer cupped his hands and yelled out, ‘Oil discovered in hell!’ Immediately, the oil prospectors wrenched the lock off the door of the pen and out they flew, flapping their wings as hard as they could for the lower regions. ‘You know, that’s a pretty good trick,’ St. Pete said. ‘Move in. The place is yours. You’ve got plenty of room.’ The old fellow scratched his head and said, ‘No. If you don’t mind, I think I’ll go along with the rest of ‘em. There may be some truth to that rumor after all.’

—Warren Buffett retelling a favorite story of Ben Graham

Too often, we learn what to do in an uncertain situation from observing others. We wait for others to “confirm” the right course of action rather than assuming the responsibility to figure it out ourselves. Psychologist Robert Cialdini calls the search for confirmation “social proof.”³ Social proof provides a mental shortcut. Rather than having to think through each step of a problem, people can simply watch their comrades and follow their lead. Then they ride on their coattails.

In the markets, herd behavior usually ends in losses for the latecomers. Investors succumbing to social proof and herding have depended on others’ critical decision making. When herd leaders are shown to be wrong, most mistaken investors then begin to lose faith and bail out. However, for many, strong emotional defense mechanisms kick in. They cannot accept that their beliefs and their leaders are wrong.

Such true believers were among the investors promoting Internet stocks both on the way up and on the way down in the early 2000s. They could not change their firm beliefs about the promise of Internet stocks. It wasn’t until many of the stock analyst cheerleaders of the Internet bubble were indicted for crimes in 2002 that they finally lost the mass of their followings.

Strangely, even after the “new Internet economy” was shown to be a fantasy, many true believers continued to proselytize vigorously. Why would anyone continue to identify with a style of thinking that had been proven wrong, much less try to spread the word? It is too painful for these proselytizers to accept defeat, so in a move reminiscent of loss aversion, they hold on for any sign of hope, and even try to gather new converts. In the minds of die-hard believers, the greater the number of people who believe their doctrine, the more likely they themselves are to be correct.

Sometimes investors will feel compelled to follow a price trend. This is a type of “herding-by-proxy.” They know others are buying the stock, but they don’t know who. When a stock is trending, people are prone to believe that the investors driving the price move know the future better than them. They then “chase” the trend higher. Some investors wait for such price “confirmation” (favorable trend) before entering an investment. An expected price movement “confirms” that one’s opinions were correct, and it now feels safe to open a position.

If the market is declining sharply, and investors feel nervous, they will look at the actions of acknowledged leaders, to see how best to respond. Investors especially look to those they see as similar to themselves. If an investor identifies with members of his investing club more than Wall Street personalities, then he will likely take his cues from his colleagues during times of uncertainty, and especially from the acknowledged leaders of the club.

SOCIAL COMPARISON

“After reading some part of the history of Alexander, Caesar sat a great while very thoughtful, and at last burst out into tears. His friends were surprised, and asked him the reason of it. “Do you think,” said he, “I have not just cause to weep, when I consider that Alexander at my age had conquered so many nations, and I have all this time done nothing that is memorable?”

—Plutarch in Life of Caesar

At that stage in his life—his mid-30s—Caesar was known as an accomplished lawyer, second only to Cicero, but also as a man too much in debt for his own good. All his military feats—and they were spectacular—came shortly after this expression of grief. In fact, after lamenting his inferior status to Alexander the Great, Caesar moved quickly to pay off his debts and conquer previously independent tribes of Spain.

Caesar was reacting to an unfavorable social comparison. He derived his goals and personal expectations from the life of Alexander the Great, and he calibrated his performance against that of his role model. After realizing that he had fallen behind Alexander’s example, Caesar immediately set about to repair his creditworthiness and reestablish his military reputation.

Social comparison can explain one’s level of satisfaction with their financial circumstances. Most people prefer being the “big fish in a small pond” when it comes to their wealth. In 1995, Harvard researchers asked subjects if they would prefer to live in a society where they had an income of $50,000 and the average person had an income of $25,000, or would they prefer to have an income of $100,000 in a community where the average person had an income of $200,000 (prices were specified as constant). Among the 159 students interviewed, 52 percent preferred the $50,000 income. Thirty-five percent of the 75 Harvard faculty and staff answered similarly. They chose to earn half as much money in absolute terms as long as they could make twice as much as the average in their community.⁴

Comparisons to peers not only drive goal pursuit, they also motivate us to overcome deep fears. Albert Bandura, a famous social science researcher, has shown that people can be cured of phobias simply by watching someone they identify with, who has a similar phobia, overcome it themselves. Adults with herpephobia (fear of snakes) can be cured of their fear by watching videos in which actors, pretending to be fearful of snakes, gradually overcome their phobia on screen. By the conclusion of the video, the actors have the snake draped over their shoulders.

Bandura did a study with nursery-school-age children who were terrified of dogs. The fearful children watched other children play with dogs for 20 minutes each day. After four days, 67 percent of the previously terrified children were willing to climb into a playpen with a dog and remain confined there, petting and scratching it, while everyone else left the room. The children recovered from their fear even more quickly when watching a video with a variety of children playing with dogs. Apparently, social proof works best when the proof is provided by lots of other people.⁵

Bandura’s study may apply to the weakening of investors’ risk aversion. Investors’ fear of a risky market sector declines as they watch others buy into it. On my own, I never would have bought Neurocell stock. Hearing about my friend F and our other mutual friends buying shares of Neurocell lowered my risk perception. Without doing my own due diligence, I was convinced that Neurocell was a guaranteed winner based on watching other people. My usual cautionary red flags had been lowered by the siren song of guaranteed profits and shared experience.

ASCH AND CONFORMITY

In 1951, social psychologist Solomon Asch devised an experiment to examine the extent to which pressure from other people could affect one’s perceptions. A participant was placed in a group of 8 to 10 other “participants” (actually confidants of the experimenter). The group was shown a picture like that in Figure 17.1 and told that the experimenter was studying visual perception. Each group member was then asked to state out loud which line in Exhibit 2 most closely resembled that in Exhibit 1. The actual experimental subject answered second to last.

FIGURE 17.1 Experimental columns similar to those used by Solomon Asch.

The experimenter’s confidants were instructed to report that lines C or B were most closely related to the line in Exhibit 1 on 12 of the 18 trials—a clearly false answer. Out of 50 subjects in this experiment, 37 conformed to the majority at least once, and the average subject conformed on 4 of the 12 trials. After further experiments, Asch concluded that people conform for two main reasons: because they want to be liked by the group and because they believe the group is better informed than they are.

INFORMATION CASCADES

Investors typically get their investment information from similar sources—data providers, Securities and Exchange Commission (SEC) filings, a company’s customers and suppliers, corporate executives and employees, and the media. While investors have different ways of processing the information, there is a limited number of potential sources.

At times, the available information leads investors to similar conclusions. When these conclusions are acted on, they cause market price movements. Some investors take their directional cues only from the market price action, which they use as a proxy for the actions of better-informed investors. An informational cascade occurs when someone, having observed the actions of those preceding, mimics their behavior.

It’s not only price action that can induce an informational cascade by communicating what others are thinking and feeling. Many investors inadvertently observe the verbal, body language, and emotional cues from their colleagues and media personalities. This nonverbal communication reflects “the pulse of the market.”

The downside of such nonverbal communication is that people who interact with each other frequently tend to think and behave similarly.⁶ They derive similar conclusions from new information, and they respond in kind. Studying the language and nonverbal cues of people within such a group can provide insight into their collective reasoning. As seen in Chapter 1, by understanding biased collective reasoning an outsider can gain the ability to identify market opportunities.

Stock message boards are a common gathering place for investors who wish to discuss a stock’s future (and who want to debate each other’s competence). Amidst the name-calling and raucous debate on stock message boards, researchers have found that useful information can be extracted from the language that participants use.

In a fascinating and technically demanding study, Professor Sanjiv Das at Santa Clara University and colleagues analyzed 103,000 stock message board postings from 12,000 unique users over a seven-month period. The researchers found that there is a positive correlation between the number of postings, stock trading volume, and subsequent stock price underperformance. More messages are written as stock prices decline, and the opinions of investors become more diverse (and presumably less bullish) as prices fall. Loss aversion is evident in posting discussions, with investors hoping for a price rebound. Overall message board sentiment is a reaction to prior trading volume and price action. According to Das, there was no predictive power to be gained by measuring sentiment.⁷

STANLEY MILGRAM AND THE SHOCKING TRUTH

Many investors do not realize the extent to which they are influenced by market experts and opinion leaders. One classic and disturbing study on the “authority effect” was carried out in the decades following World War II. Stanley Milgram, a professor at Yale University, was planning to investigate the obedience of Germans to authority, with the goal of gaining insight into the rise of authoritarian Nazism.⁸ He performed his pilot experiments at Yale, and he quickly realized that he didn’t need to go overseas to find incredibly compliant subjects.

Milgram’s experiments provide clear evidence that people are wired to follow authority, even in very sadistic ways. When experimental subjects arrived at Milgram’s psychology lab, they were met by two people: a researcher wearing a lab coat and carrying a clipboard and another person, average in all respects, introduced as another volunteer. The other “volunteer” was actually an experimenter posing as a research subject.

The subjects were told that the experiment was a test of how punishment affects learning and memory. The experimenter posing as a volunteer was selected as the learner, while the real volunteer was assigned to be the teacher. Of course, the teacher believed that the learner was just another volunteer, but actually it was the teacher who was being studied in this experiment.

The learner attempted to memorize a list of word pairs. After memorization, the learner entered a lab room, where he could be viewed through a glass wall. The learner was strapped into a chair, and his skin was wired with false electrodes that appeared to deliver electric shocks. As the teacher read the first word of a word pair, the learner tried to remember and name the other half of the pair. If the learner recalled incorrectly, then the teacher was told to administer an electric shock.

For every wrong answer, the teacher announced the voltage of the shock to be delivered and then flipped a switch to administer it. After each shock, the voltage was increased by 15 volts for the next one. If the teacher asked about the severity of the electric shocks, the researcher responded that while painful, they caused “no permanent tissue damage.” In general, the first part of the test proceeded normally. But as the voltage climbed, the learner began to complain.

The learner grunted in pain at 75-, 80-, and 105-volt shocks. At 120 volts, the learner yelled into a microphone connected to the teacher’s control booth that the shocks are really starting to hurt. At 150 volts, the learner shouted in to the microphone, “That’s all! Get me out of here! Get me out of here, please! Let me out!” The researcher continued to pose the next question for the teacher to ask the learner. Inevitably, the teacher continued. Between 200 and 300 volts, the learner writhed and shrieked when the shocks were administered. The learner kicked the wall, screamed, and pleaded to be released.

Remember, the learner is an actor and no real shock was being delivered, but the teacher didn’t know this. Two-thirds of the volunteer teachers pulled every one of the shock switches and continued to engage the last switch at 450 volts until the researcher ended the experiment. None of the teachers stopped until 300 volts, at which point the learner was emitting, in Milgram’s words, “definitely an agonized scream.” Many of the teachers appeared anguished at this point, asking the researcher to please stop the experiment. The researcher simply droned on with the next question, and the teachers complied with the next level of shock. At 300 volts, the learner shouted that he would no longer provide answers to the memory test. That point was the first time that any of the teachers refused to go on.

Milgram and his colleagues were surprised by the results. Before the experiment they had asked students and colleagues to guess how many volunteer teachers would go up to 450 volts. Their answers fell in the 1 to 2 percent range. A separate group of 39 psychiatrists predicted that only 1 in 1,000 would be willing to continue to the end of the experiment.⁹ Actually, two-thirds of the volunteers went to the maximum voltage. Apparently, people think they are much more independent of this effect than they actually are.

In a modification of the experiment, even when the learner exclaimed that he had “heart trouble” and the shocks were beginning to affect his heart, 65 percent of teachers proceeded to the maximum voltage. In yet another variation, two researchers were present. As the shock intensity increased, and the learner cried out for release, one researcher told the teacher to go on, and the other said to stop. Typically, the teachers scanned back and forth between researchers, looking and asking for some indication of who was the higher authority. When they couldn’t figure out who was superior, the teachers stopped the experiment.

NICE CLOTHES, FAST CARS, AND FANCY TITLES

“Clothes make the man. Naked people have little or no influence on society.”

—Mark Twain

When meeting someone for the first time, it is not uncommon to inquire about his or her line of work. Business cards list one’s position in an organization. Short biographical sketches on company web sites refer to schools attended, degrees earned, jobs held, and articles or books published. A pedigree can establish one as an authority, while actual competence must be sorted out later.

More easily apparent at a distance than titles and pedigree, one’s clothing also conveys authority. Researchers in Texas discovered that three and a half times as many people follow a jaywalker into traffic when he is dressed in a well-tailored suit as when wearing a work shirt and trousers.¹⁰ Besides clothing, jewelry and cars are also visible signs of wealth.

In a San Francisco study, researchers driving either luxury cars or economy cars stopped in front of a green traffic light. Nearly all motorists behind the economy car sounded their horns, and two even rammed into its rear bumper. Fifty percent of the motorists waited patiently behind the luxury car, never beeping their horns, until it drove on.

Most of us don’t believe we act with such deference to authority. We wouldn’t wait behind a luxury car or blindly follow the recommendations of experts. The San Francisco researchers asked a class of students to estimate what they would do if stuck behind the luxury or economy car at a green light. Male students estimated that they would honk faster at the luxury car than at the economy car, believing they would do the opposite of what actually occurred. ¹¹

In the electric shock experiment, Milgram’s colleagues greatly underestimated the percentage of people who would increase the voltage to the maximum. We don’t think it could be us. Social psychologist Robert Cialdini describes obedience to authority as occurring beneath awareness, in a “click, whirr” reaction. Subconsciously, after receiving an instruction from an authority, we move from thinking about a situation to reacting. “Information from a recognized authority can provide us with a valuable shortcut for deciding how to act in a situation.”¹²

Financial analysts are Wall Street’s authorities on stocks and market sectors. Their opinions and recommendations lead to shifts of billions of dollars across securities. Given the results of Milgram’s experiment, it is no surprise that investors herd into the stocks recommended by analysts. This is a problem when analysts are corrupt or unethical. In the late 1990s, when star Internet analysts Henry Blodgett, Mary Meeker, or Abby Joseph Cohen said “Buy,” millions followed at their own peril.

THE NEUROSCIENCE OF COOPERATION

Serotonin appears to modulate the acquisition of socially cooperative behavior. The amino acid precursor of serotonin is tryptophan (Trp). Its role in the brain is described in Chapter 4. When tryptophan is removed from the diet, brain levels of serotonin are depleted. In a prisoner’s dilemma game (a trust and cooperation game, defined in the glossary), Trp-depleted volunteers defected more and cooperated less on the first day after depletion, as if low serotonin levels increased self-interest and decreased cooperativeness.

On functional magnetic resonance imaging (fMRI) scanning during the prisoner’s dilemma task, anterior cingulate gyrus and orbitofrontal cortex activation were decreased in Trp-depleted volunteers, implying that people with low serotonin require less social reinforcement and use less prefrontal cortex (impulse inhibiting) input when making sociofinancial decisions that affect other people.

In a modified version of Asch’s experiment described above, neuroscientists found that individuals who go against peer pressure and give the correct answer have increased amygdala and caudate activation, which reflects the tremendous emotional strain undergone by nonconformists and the courage needed to disagree with obviously erroneous accepted opinion.¹³

ANALYSTS’ ABUSE OF AUTHORITY

“When I was an analyst . . . I placed too much stock in the opinions of those who seemed to know more than I did (my fault, not theirs). More unsettlingly, I saw others do the same with me.”

—Henry Blodgett, former Wall Street analyst ¹⁴

Security analysts work in a high pressure environment, often jockeying to develop cozy relationships with corporate management. The performance of their stock recommendations is monitored closely by rating agencies. It’s no wonder that new analysts might feel pressured to “follow the leader” when a more successful analyst changes a stock recommendation.

Finance professor Ivo Welch found that analysts are significantly influenced by each other’s opinions. A change in the buy or sell recommendation of an analyst influences the recommendations of the next two analysts who issue opinions. ¹⁵

During the late 1990s, many Wall Street Internet stock analysts were paid high salaries and encouraged to tout stocks that they actually held in disdain. Analysts’ employers, the major investment banks such as Merrill Lynch, Deutsche Bank, and Morgan Stanley, wanted the lucrative banking business of the companies whose shares their analysts were promoting. The banks demoted or fired analysts who put “sell” recommendations on the companies whose business they were wooing.

Morgan Stanley made millions in fees raising money for Priceline. One of Morgan’s Internet analysts, Mary Meeker, recommended buying Priceline’s stock at $134 a share. When it fell to $78, she repeated her buy recommendation, and she kept recommending Priceline as a buy as it fell to less than $3 per share.¹⁶

Merrill Lynch analyst Henry Blodgett (quoted above) covered the stock of Pets.com. Much of Pets.com’s financing was raised by Merrill Lynch, who made millions. Blodgett placed a buy recommendation on Pets.com at $16 per share. When it fell to $7, Blodgett said “buy” again. Again a “buy” at $2, and again at $1.69. When it hit $1.43 a share, Blodgett downgraded the stock to “accumulate.” Pets.com was ultimately delisted from the stock exchange. Investors may have lost a fortune, but in 2000 Blodgett and Meeker were paid about $15 million each.¹⁷

The Internet stock frenzy was enhanced by television business channels. CNBC, CNNfn, and other financial television channels needed guests for their programming segments. Some analysts appeared on CNBC’s Squawk Box, hosted by Mark Haines. After a stock was recommended by a guest, Haines remembered, “I’d look down at the quote machine, and all of a sudden it had jumped 5 bucks or 10 bucks.” Thousands, new to investing, were watching the show’s guests with no idea that a conflict of interest might exist between the objectivity of their stock recommendations and their income. CNBC now requires its guests reveal conflicts of interest before they appear.¹⁸

Such conflicts were well known on Wall Street, and it is unfortunate that they were not somehow made clear to amateur Internet stock investors. Indignation arose in the political world to satisfy constituents who had lost millions of dollars following analysts’ recommendations from 2000 through 2002. Are the losses the fault of the analysts who unethically (but not illegally) touted stocks that they privately despised, or can we blame the millions of investors who, driven by greed, piled into worthless stocks on the advice of a presumed expert?

THE HERDING HABIT

“It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

—Upton Sinclair

Mutual funds have also been found to exhibit herding behavior, especially growth and small-cap oriented funds. For funds, herding is not always irrational; in fact, herding is profitable for the vanguard of mutual funds. The stocks the herd buys tend to outperform those they sell by 4 percent over the subsequent six months. ¹⁹

Herding by mutual funds is related to word-of-mouth communication between portfolio managers. In fact, portfolio managers in the same city demonstrate greater herding. In a study of 1,635 mutual funds headquartered in 15 large U.S. cities, funds located in the same city traded in concert more often and to a greater degree than funds located in different cities. ²⁰

Researchers looked at how analysts treat information that they believe is “private” to them. Their sample was comprised of 1.3 million forecasts by 5,306 analysts, relative to 3,195 firms, from 1985 to 2001. On average, analysts tended to overweight information that they believed to be private. Yet analysts tend to overweight their private information more when their forecast is more favorable than the consensus forecast but underweight their private information when their forecast is less favorable than the consensus. That is, most analysts interpret their private information as reflecting favorably on the companies they cover. The authors found that this misweighting is not due to an explicit cognitive bias, rather analysts misweight in order to draw more trading commissions to their firm.²¹

If you’re an individual investor, learning about how your unconscious biases sabotage you might make you feel a little jaded. How can you possibly succeed under such adverse psychological circumstances? Some individual investors adopt a contrarian perspective on the markets.

LIVING THE CONTRARIAN LIFESTYLE

“The most important quality for an investor is temperament, not intellect.... You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”

—Warren Buffett

Investors who consider themselves contrarians are generally “countertrend” specialists. There is no uniform personality style, though many contrarians are suspicious of popular investing techniques and the “in-crowd.” I had a fascinating telephone conversation with one die-hard contrarian.

James had been a floor trader in London and emigrated to the United States to set up a hedge fund. He had done well for himself on the floor, and he had an excellent reputation as a trader. Unfortunately, he had little respect for his colleagues, explaining, “They just play ‘follow the leader.’ It’s stupid, really, makes me sick.”

He was having trouble marketing his hedge fund because he despised the people he was marketing to, “They don’t know squat about the markets.

They just have some fancy degree and they knew the right people at some pension fund.”

I mentioned that he seemed pretty hostile to his potential clientele.

James responded, “Look, I don’t like morons!” He didn’t lack opinions.

I asked, “How are you going to sell this fund?”

“I need to find people like me, who really understand what’s going on in the markets.”

I asked why that was hard. He told me, “I make my money off the idiots who follow the trends. I know when they are turning, and that’s my talent. I NEVER trade with a trend! But most people are part of the trend—that’s what makes the trend in the first place. None of the big investors or pension funds understand why I would go against what everyone else is doing. They look at me like I’m crazy.”

“If you make them money, I don’t see why they’d think you’re crazy.”

“It’s my personality, okay? I won’t do anything that other people do. I live a contrarian life. If I go to see a movie at a theater and there’s a line for it, then I’ll go to a different movie. I won’t do anything that other people do. I married my wife because people didn’t think I would.”

He was contrarian to the core, and he had found a niche in the markets that fit his personality. And he was probably right—few investors successfully identify the top or bottom of a trend because they are caught up in the story and unable to think clearly or critically.

Value and countertrend investing strategies are more characteristic of contrarians. Contrarians have the innate advantage of being able to search for opportunities away from the crowd. They often seek for solid investments in overlooked sectors. Every sector rotates into and out of popularity, given time.

Contrarians are also inclined to short emerging trends, which can be very painful. If you’re contrarian, be sure to identify clear signs of reversal or exhaustion before shorting a popular security or sector.

Contrarianism can be a destructive habit. Some investors who call themselves contrarians see only danger, thus missing out on long bull markets while fretting about an impending crash. There is a difference between excessive anxiety and healthy critical thinking, so be sure to understand where you fall between those two. Anxious people won’t last long as contrarians.

ADVICE FOR HERD ANIMALS AND TREND FOLLOWERS

In the marketplace, individual investors who herd are more likely to follow stock tips, the recommendations of “gurus,” and rumors, rather than making independently researched investment decisions. Most investors fit into this group.

If you like to be aware of crowds and trends, be sure to keep perspective on the rationale behind the crowd’s behavior. If you are a trend follower, consider adopting a strategy (such as momentum or growth) that accounts for your social personality. Investing in the “hot” sector is okay as long as you are aware that trends change, and you have definite rules for when to close out your positions.

If you’re social, use it to your advantage. Learn about the new trends and fads, and see if you can identify strategies to take advantage of these. Avoid listening to financial media outlets such as CNBC and popular magazines. Due to the authority effect, virtually everyone is susceptible to jumping on the latest investment bandwagon publicized in the media, and it is typically a very bumpy ride.

ADVICE FOR INVESTMENT COMMITTEES

Investment committee decisions are often constrained by the members’ desire to conform. Standing out from the group, especially for new or young employees, can be quite embarrassing. Their fear of making a foolish comment often restricts their input.

Professor Hersh Shefrin described several techniques for debiasing imvestment committees in his 2006 book, Behavioral Corporate Finance:

1. Ask group members to refrain from stating personal preferences at the outset of the discussion.

2. Explicitly cultivate debate, disagreement, and the sharing of information.

3. Designate one member of the group to play devil’s advocate for each major proposal.

4. Regularly invite outside experts to attend meetings, with the charge that they challenge the group not to behave like meek conformists . . . in the drive for consensus. . . .²²

This chapter has examined the psychological origins of herding. Most investors inadvertently follow the advice of leaders, experts, and the well dressed. Herding is more likely when decisions are complex or the future appears especially uncertain. Contrarians actively use their outsider perspective to their advantage. Investment committee members are constrained by internal pressure to conform.²³