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Following the crowd: Good for survival - bad for investment

 
Andrew Williams
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It is often difficult to go against the crowd (Source: Getty)

The instincts that helped to keep our ancestors alive tens of thousands of years ago can be a positive disadvantage when it comes to modern-day investing, says Andrew Williams of The Value Perspective blog...

“Where all think alike, no-one thinks very much.” - Walter Lippman, The Stakes of Diplomacy

Stopping at a red light is a practice these days often more honoured in the breach than the observance by London cyclists.

One set of traffic lights where this is particularly in evidence forms part of the giant road junction in South London better known as Elephant and Castle, which I happen to pass through myself as I cycle to work every morning.

You can probably imagine the scene. Cyclists and motorists all come to a complete stop when the light turns red and the former then pick their way to the front. They wait. And they wait.

And then one cyclist runs the red light. The remaining cyclists all look around at each other and then a few more go – and, before you know it, all the cyclists are starting off ahead of the lights.

Now, as I cycled to work this morning, I happened to be listening to the audiobook version of Influence: The Psychology of Persuasion.

Written in 1984 by US psychologist Robert Cialdini, the book can be see as a forerunner to a lot of today’s work on behavioural economics – not least the section on ‘social proof’, which was what was coming though my headphones at the Elephant and Castle junction.

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As we noted the last time we touched on Cialdini’s work on The Value Perspective, in Under the influence, social proof essentially revolves around the idea that, when people are faced with an unfamiliar situation or are otherwise uncertain about what course of action to take, they tend to look to those around them – and especially their peers – for an indication of how to proceed.

Clearly this instinct would have worked to the advantage of human beings as we evolved – helping, for example, to keep us out of the jaws of sabre-toothed predators many thousands of years ago.

In a more modern context, as Cialdini noted in his book, it also led to the creation of canned laughter, which leads audiences to believe the sitcom they are watching is funnier than they otherwise might.

Human instinct can be unhelpful for investing

The instincts that worked to the advantage of our ancestors – and apparently still work to the advantage of the producers of, say, Mrs Brown’s Boys – can, however, be positively unhelpful when it comes to investing.

For one thing, as we noted in Boom, it can drive ‘FOMO’ – that is, fear of missing out – which has been a key ingredient of pretty much every financial bubble or crash since the dawn of time.

Acting in accordance with social proof – that is, going along with the crowd – makes people feel comfortable because, in evolutionary terms, it meant fewer life-threatening mistakes were made.

Conversely, in the context of investment, in pursuing a value strategy, we are always looking to go against the crowd and to buy assets that would make most people feel deeply uncomfortable because that is where returns are to be made.

Being the contrarian that I am, at Elephant and Castle I waited for the light to turn green.

  • Andrew Williams is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

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