Why it's important for investors to have conviction--especially when going against the crowd.
This is the fourth article in the Behavioral Finance and Macroeconomics series. We will explore the effect that behavior has on markets and the economy as a whole--and how advisors who understand this relationship can work more effectively with their clients. (Access past articles here.)
In the last article, we discussed the details of a bias called herding. Because of herding, investors can crowd into trades without careful consideration. Today we'll discuss a related psychological behavior known as groupthink. Groupthink isn't the same as herding. When herding, investors aren't doing much thinking--they are just acting by following the herd. Groupthink, meanwhile, has its own unique character.
Groupthink occurs when members of group reach a consensus of opinion without considering alternative solutions. This consensus happens either because the members of the group don't have the patience or the capacity to reach different conclusions, or because they don't want to upset the "status quo" of a situation because consensus has otherwise been reached. As a result, people can reach faulty conclusions as a group--and investors are no exception.
The term "groupthink" was originally coined in 1972 by Yale University social psychologist Irving Janis. Janis believed groups of intelligent people sometimes make poor decisions because groups prevent contrary information from being given the proper level of due diligence.
Groupthink in Investing
In mid-2016, prevailing wisdom said two things: central banks will continue to intervene in the global markets, and economic growth will be anemic. Economic forecasts from Consensus Economics in mid-2016 noted that the average prediction was for the U.S. to expand 2.4% in 2017--the lowest rate since 2012. Furthermore, economists were in near-complete agreement on this forecast.
As a result, high-quality, long-dated government bonds remained at historically low yields. In the stock market, "safe" stocks, such as minimum volatility stocks, traded at their highest valuation premiums to the wider global market since 2002, measured by price-to-book, price-to-cash earnings, and price-to-forward earnings. The demand for quality and consistency of earnings, together with the desire for stable dividends, drove companies such as Coca-Cola, General Mills, and Johnson & Johnson to new highs.
This is an example of classic groupthink in action. These stocks and bonds became very expensive because the majority of market participants agreed on a single consensus: continued intervention by global banks and anemic global economic growth.
As we know, the bubble in minimum volatility stocks popped. In the midst of groupthink, the challenge is having the conviction to know you are right even if it goes against the crowd, and the courage to take action in your portfolio. That's what being a contrarian is about. Sir John Templeton was famous for saying that the best time to buy stocks is "when there's blood in the streets." Howard Marks from Oaktree constantly reminds us in his letters that human nature compels investors to "buy high and sell low," and his advice is to do just the opposite. When groupthink dominates and valuations reach extremes, it's probably time to take the opposite side of the trade.
Michael M. Pompian, CFA, CAIA, CFP, is the chief investment officer of Sunpointe Investments, an investment advisor to ultra-affluent clients and family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients.