Eye On Behavioral Finance: Groupthink

“In the fight between you and the world, back the world.”
-Franz Kafka

Franz Kafka posthumously became renowned for his writing, but while alive actually made his living, ironically, in the finance department of a large insurance company. One of Kafka’s most widely noted works is The Trial. The protagonist in The Trial, Josef K, is awakened one morning, arrested and prosecuted for an unspecified crime. The reasons for the arrest are never known. I’m sure after suffering through an almost 40% decline in the major market indices year-to-date, many investors can relate to Josef K and the idea of being punished for an unknown crime…

While the trials and tribulations of Kafka’s characters may resonate with us, it might be perceived as a stretch to think that we can learn many investment lessons from them. That’s why the aforementioned quote prompted the topic for this post, which is Groupthink. The concept of Groupthink was reportedly first coined in 1952 by William H. Whyte when he wrote in Fortune Magazine:

“We are not talking about mere instinctive conformity – it is, after all, a perennial failing of mankind. What we are talking about is a rationalized conformity – an open, articulate philosophy which holds that group values are not only expedient but right and good as well.”

In simpler terms, and paraphrased from Wikipedia, Groupthink is a method of reaching a consensus decision without critically analyzing the decision, but rather accepting the decision, or view, as correct simply because others support it. The idea of the independent view is lost out, ultimately, to the importance of group cohesiveness.

The investment world is loaded with examples of Groupthink and investment results that are subpar as a result. At Research Edge, we actually quantify Groupthink in order to augment an existing investment thesis’ and take positions that counter the prevailing view. We use various methodologies to counter Groupthink. We quantify them as factors within our multiple factor macro model. Two of the easier factors to identify are Hedge Fund Beta and Sell Side Sentiment.

We review shareholders lists to identify Hedge Fund Beta (or “hedge fund hotels”). We also review sell side opinions to identify stocks that have an overwhelming number of either positive or negative ratings.

I’m not sure “hedge fund hotel” has entered the wide investment lexicon as of yet, but the concept is simple – it is a stock that has a high percentage of hedge fund ownership. We typically consider a stock a “hedge fund hotel” when hedge funds comprise 33% of the top 1/3 of a shareholder list. For many hedge funds “trading ideas” are part of the investment process, so as these “hedgies” trade ideas, the “good” ideas tend to become over owned. In many instances, the investment rational is simply that some other “smart hedgie did the work”, so it must be a good idea and there are certain “smart hedgies” who you can’t criticize, so you just tag along and own the same stocks as them. That’s called Groupthink. We also call it Hedge Fund Beta. Being on the other side of the unwinding of a “hedge fund hotel” can be very profitable.

Sell side estimates and ratings also exemplify Groupthink characteristics that can be taken advantage of. We typical highlight as a contrarian indicator when 66% of the rankings of a stock are of one specific rating, either buy or sell. There is a wide body of evidence that supports our view that the consensus Groupthink ratings of analysts are often way off.

According to research by Robert Shiller, “analysts . . . often pay too much attention to one another instead of providing their own independent research.” The result is that both ratings and earnings estimates become redundant and are often lowly dispersed. According to Maines (1990) and Soll (1999), people often overestimate the information provided in redundant signals. As a result, we have sell side earnings estimates that are based on a foundation of conforming to consensus and an investment community that willingly accepts a lowly dispersed set of data, which inherently implies a lack of independence.

The psychological foundation behind Groupthink is based on the biological concept herding. In his book “Inside the Investor’s Brain”, Richard Petersen writes:

“Biologically speaking, herding refers to the tendency of some species of animals to seek safety in numbers. Herding occurs both when animals are threatened and when they sense that one of their numbers has found an opportunity.”

Hedge funds, and many mutual funds, are in a financial herd. Some justify their positions based on who the stock is owned by and what the well known analysts are saying. If a “smart hedgie” owns the stock and a bulge bracket investment bank has a favorable rating, a safe foundation is in place for the analyst to pitch the stock to his portfolio manager or investment committee. Conversely, these conditions also provides the portfolio manager or investment committee the “safety” to put on the position. What happens when all of these smart sell side analysts and hedgies are wrong?

In The Wisdom of Crowds, James Surowiecki provides what appears to be a juxtaposed thesis to the negative impact of Groupthink. In Surowiecki’s view, the collective knowledge of the many will lead to a better decision than a small group of intelligent experts. He provides many examples of this, such as the ability of electronic markets to predict elections better than professional pollsters, the ability of large groups to accurately predict the weight of an ox, the ability of a large group of varied professionals to find a submarine, and so on. Surowiecki, though, acknowledges early on in his book that all crowds are not created equal when he states: “Paradoxically, the best way for a group to be smart is for each person in it to think and act as independently as possible.”

There are plenty of ways to combat Groupthink. Here are a few to consider:

1. Perform research with independence at the very foundation. Start by developing your own view and then review other analysts’ expectations. When your view is most widely dispersed from the group, you are probably on to something that is worth taking a position in.

2. Foster a culture in your firm that encourages devils advocacy and taking contrary opinions, even against people in positions of power and influence. At Research Edge, we sometimes publish what call “Point and Counterpoint”, which are examples of our internal debates on different investment views that members of our firm are supporting.

At the end of the day, we call it Research Edge because most of the real edge in investment research resides on the teams asking original questions… not following everyone else’s answers to ones that have already been asked.

Daryl Jones
Managing Director
Research Edge LLC

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