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Chris Mydlo
Chris Mydlo
Articles (166) 

Don't Let the Markets Alter Your Perception

June 10, 2014 | About:

When it comes to investing, Howard Marks says that one of the most important things is “second-level thinking.” First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. All investors cannot beat the market since, collectively, they are the market. In his book, “The Most Important Thing,” Howard Marks (Trades, Portfolio) gives the following examples of second level thinking:

  • First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
  • First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”
  • First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”

Physiologically, being a second-level thinker is a difficult task to accomplish. I recently came a across a couple of studies involving conformity experiments when reading “Quiet” by Susan Cain. The experiments were first performed by Dr. Solomon Asch and later reenacted and combined with Functional MRI (fMRI) data in a study led by Dr. Gregory Burns.

Dr. Asch was a professor of psychology at Swarthmore College during his experiments. The article “Opinions and Social Pressure” was published in the magazine, Scientific American, in November of 1955. His goal was to answer the following questions:

  • Exactly what is the effect of the opinions of others on our own?
  • How strong is the urge toward social conformity?

Dr. Asch gathered student volunteers into a classroom for a psychological experiment in visual judgment. The experimenter informs them that they will be comparing the lengths of lines. He shows them two large white cards. On one is a single vertical black line to be matched against. On the other card are three vertical lines of various lengths. One of the three is actually of the same length and the others are substantially different.

Questions were asked about how the lines compared with one another. The questions were so simple that 95 percent of the students answered every question correctly. Later, when actors were planted in the groups to confidently give incorrect answers, the number of students who gave all correct answers dropped to 25 percent. That means that 75 percent of the group went along with the group’s wrong answer to at least one question. The study showed that individuals tend to accept the group’s incorrect conclusion even if it was obviously wrong to begin with. The questions that Dr. Asch could not answer were: Did the people who gave into the group do so knowing that their answers were wrong, or did social pressure actually change their perception?

Fast forwarding to 2005, Dr. Gregory Berns, a neuroscientist at Emory University in Atlanta, conducted an updated version of Dr. Asch’s experiments. The volunteers played a game in which each group member was shown two different three-dimensional objects on a computer screen and asked to decide whether the first object could be rotated to match the second. The experimenters used an fMRI scanner to take snapshots of the volunteer’s brains as they conformed to or broke away from the group.

The results confirmed Dr. Asch’s findings and gave plenty of insight of the brain activity during the experiment. When the volunteers played the game on their own, they gave the wrong answer only 13.8 percent of the time. When they played with a group whose members gave unanimously wrong answers, they agreed with the group 41 percent of the time. The scans showed activity in a network of brain regions including the occipital cortex and parietal cortex, which are associated with visual and spatial perception, and in the frontal cortex, which is associated with conscious decision making. The brain scans would be able to determine if the volunteers were knowingly giving the wrong answers, or if their perceptions had actually been altered by group activity. The latter is exactly what was displayed in the images. The brain scans showed heightened activity in the regions associated with visual and spatial awareness indicating that the group somehow managed to change the individual’s perception.

There is still hope. Not all of the volunteers succumbed to their peers on every incorrect answer, but it triggered another part of the brain during the decision making. The act of going against the group was linked to heightened activity in the amygdala, a small organ in the brain associated with upsetting emotions.

In relating these studies with the financial markets, they show the difficulty of being a second level thinker. It is not just a simple answer of fear and greed. The incorrect opinions of a large group (in our case, the market) can actually alter our perception and lead us into a herd mentality. Now compounding that with fear and greed can make it dangerous. It can lead to irrational exuberance on the upside and indiscriminate selling on the downside.

I find that a way to keep from falling into the trap is to keep an investing diary of your ideas. Review the ideas and check to see if they are well grounded by your own research. If you are feeling pressure to make a quick buy or sell decision, take a step back and reanalyze the situation. It is in our physiological makeup to be sucked into the herd mentality.

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