It’s generally agreed that value investors should be contrarians, buying when others are selling and vice versa.
But, as James Montier pointed out in chapter 14 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," that is easier said than done. He said:
“A willingness to subjugate one’s own thoughts for those of a group is a sadly common behavioral affliction.”
Can you believe your own eyes?
It turns out there are numerous human traits that push us toward conformity and away from individual thinking. He began by referencing psychological research that showed just how susceptible we are to external influence. The researchers drew four vertical lines: one on the left, which was to be the reference, and then three more lines, one tall, one the same size as the line on the left and a third that was short.
When individuals take this test on their own, they generally do quite well at it: one line is clearly too tall and one is clearly too short. When a subject was put in a room with seven others (who worked for the researchers), however, all of whom insisted the tall line was the best match for the line on the left, the individual adopted the conclusion of the group.
Montier added that the size of the group did not matter, as long as it had at least three other members: “As soon as there were at least three people giving an incorrect answer, then about one third of subjects started to conform to the group judgment.”
He also reported neuroscientists have done similar experiments while the subjects were being scanned with an MRI:
“The researchers found that when people went with the group answer they seemed to show a decrease in activity of the parts of the brain associated with logical thinking—the C-system. Simply put, they seemed to stop thinking.”
Nonconformity and fear
As if that wasn’t enough, neuroscientists have also found that when an individual takes the road less traveled, he or she experiences fear. They found that a conflict with the group stimulated the part of the brain that processes emotion and fear (the amygdala).
And the effects go on. The part of the brain that handles actual physical pain was stimulated when a subject (in an MRI) was left out of a game which originally involved him or her. In other words, “Doing something different from the crowd is the investment equivalent of seeking out social pain.”
Investing despite, or with, the fear
Montier didn’t have far to look when searching for contrarian investors, since most successful value investors have taken their own roads, regardless of popular opinion. Among those he cited are Sir John Templeton and John Maynard Keynes. The latter said:
“The central principle of investment is to go contrary to the general opinion on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.”
Not everyone can or wants to be a contrarian. Research involving institutional fund managers backs up this assertion. One curious mind looked at two years’ worth of quarterly data and concluded the managers had handicapped themselves by 17%. The stocks they sold the most outperformed the market by 11%, while the stocks they bought underperformed by 6%.
Further, other research has found that members of groups rate other members higher when they provide information that is commonly believed by the group. Those who argue for new perspectives received lower ratings. Turning from individuals to groups, the latter show what Montier called “a disturbing habit of focusing on common information.”
When a group opts for too much conformity, leading to bad decisions, the behavior is called “groupthink.” Montier said groupthink leads to “a deterioration of mental efficiency, reality testing and moral judgement.” Its presence is blamed for many high-profile failures, including the Vietnam War, the Bay of Pigs debacle and the Challenger space shuttle disaster.
Montier attributed eight symptoms to groupthink:
- The illusion of invulnerability: Excessive optimism that leads to extreme risks.
- Collective rationalization: Warnings are discounted and key assumptions are not challenged.
- Belief in inherent morality: Because members believe they are right, they ignore the ethical or moral consequences of their decisions.
- Stereotyped views of out-groups: Montier reminded readers of the pressure on managers who refused to jump on the dot-com bubble in the late 1990s.
- Dissenters face direct pressure: Those who disagree are put under pressure to remain silent about information and ideas that could undermine the group view.
- Self-censorship: Doubters keep contrary information and ideas to themselves.
- Illusion of unanimity: The majority view is considered to be unanimous.
- “Mind guards” appointed: Some members protect the group and leaders from contrary information.
Montier also reported that while most of us like to think we are contrarians, we often are not and calls this the “introspection bias”:
“One final word of warning to all budding contrarians—we all like to think we are independent thinkers. Sadly, it is just another one of our failures to actually see our behavior as it really is (known as the introspection bias we discussed in the Introduction). We see others’ behavior as a demonstration of their underlying nature, while we see our own actions as driven by the circumstances we face (the fundamental attribution error).”
Three essential traits of contrarians
Obviously, it is possible to be a contrarian investor despite the inherent biases that push us toward groupthink: Successful value investors have learned how and Montier argued there are three traits that make some of us critical thinkers.
First, the courage to be different. He quoted hedge fund manager Michael Steinhardt, who said:
“The hardest thing over the years has been having the courage to go against the dominant wisdom of the time, to have a view that is at variance with the present consensus and bet that view.”
“You can’t be a good value investor without being an independent thinker—you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value.”
Third, being persistent and sticking to your principles. This time he quoted Benjamin Graham:
“If you believe that the value approach is inherently sound then devote yourself to that principle. Stick to it, and don ’t be led astray by Wall Street’s fashions, illusions and its constant chase after the fast dollar. Let me emphasize that it does not take genius to be a successful value analyst, what it needs is, first, reasonably good intelligence; second, sound principles of operation; and third, and most important, firmness of character.”
In chapter 14 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," Montier dug into the biases against independent thinking. He also told us about three traits we would need to develop to become contarians (and good value investors).
First, he took on the way that we are naturally inclined to go along with groups. He referred to psychological research that showed how individuals are pulled into a group orbit.
Second, he addressed how fear and pain can accompany independent thinking: Diverging from conventional views is equal to social pain.
Third, he took a run at groupthink and described eight symptoms that characterize this state. Failure to confront groupthink can lead to disastrous failures.
Finally, Montier suggested investors (and others) need to develop three character traits to become true independent thinkers and contrarians: The courage to be different, being a critical thinkers and sticking to your principles.
The author is a member of the asset allocation team at GMO, the firm founded by Jeremy Grantham (Trades, Portfolio) in 1977. According to his Amazon profile, he was previously co-head of global strategy at Société Générale (XPAR:GLE, Financial). The author of three books, he is also a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. The book we are discussing was published in 2010.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)