Premium Value Investing NewsletterDownload Free Issue

Why Smart People Like You Make Stupid Money Mistakes

Imagine yourself in the following situation: You sign up for a psychology experiment, and on a specified date you and nine others whom you think are also subjects arrive and are seated at a table in a small room.

You don’t know it at the time, but the nine others are actually associates (planted subjects) of the experimenter (they know about the experiment), and their behaviour has been carefully scripted.

You’re the only real subject.

The experimenter arrives and tells you that the study in which you are about to participate concerns people’s visual judgments.

He places two cards before you. The card on the left contains one vertical line. The card on the right displays three lines of varying length.


He asks all of you, one at a time, to choose which of the three lines on the right card matches the length of the line on the left card. The task is repeated several times with different cards.



Value Investing Workshop in Hyderabad
After a great response from Mumbai and Delhi, I have my Art of Investing Workshop in Hyderabad on 20th July (Sunday). If you want to attend and want to claim an early-bird discount, click here to register now!



On some occasions, all or a majority of other “subjects” unanimously choose the wrong line. It is clear to you that they are wrong, but they have all given the same answer.

What would you do? Would you go along with the majority opinion, or would you “stick to your guns” and trust your own eyes?

What Solomon Asch Found
In 1951, social psychologist Solomon Asch devised this experiment to examine the extent to which pressure from other people could affect one’s perceptions.

Asch showed bars like those in the above image to college students in groups of 8 to 10. He told them he was studying visual perception and that their task was to decide which of the bars on the right was the same length as the one on the left.

As you can see, the task is simple, and the correct answer is obvious. Asch asked the students to give their answers aloud. He repeated the procedure with 18 sets of bars.

Only one student in each group was a real subject. All the others were “planted subjects” who had been instructed to give two correct answers and then to some incorrect answers.

Asch arranged for the real subject to be the second last person in each group to announce his answer so that he would hear most of the “insiders” incorrect responses before giving his own. Would he go along with the crowd?

To Asch’s surprise, 37 of the 50 (that’s 74%!) subjects conformed themselves to the ‘obviously incorrect’ answers given by the other group members at least once, and 14 of them conformed on more than 6 times out of the “scripted” trials.

Asch was disturbed by these results. As he said after the experiment…

The tendency to conformity in our society is so strong that reasonably intelligent and well-meaning young people are willing to call white black.

This is a matter of concern. It raises questions about our ways of education and about the values that guide our conduct.

Why We Conform
Now, since you know of this experiment, you might consider the real subject foolish to go with the scripted answers of the other nine planted subjects.

But the truth is that – most of all of us would conform to the majority when placed in such a situation.

Now, why do most of us conform to a group’s line of thinking, even if it is obviously wrong, and especially when a lot of other people who form that group think it is true?

There are two main reasons –

  1. We want to be liked by others, especially by a group, and
  2. We believe the group is better informed than we are.

What is more, conformity increases when…

  • Size of the group increases – Many people agreeing to a specific thing
  • Task at hand is difficult – Like identifying quality businesses for investment
  • We are uncertain – We find comfort in people’s predictions
  • Group as a whole is (or seems) influential – The majority are either smartly dressed and/or they speak well (look at CNBC!)

Suppose you go to a dinner party and notice to your dismay that there are three forks of different sizes beside your plate. When the first course arrives, you are not sure which fork to use.

If you are like most people, you look around and use the fork everyone else is using. You do this because you want to be accepted by the group and because you assume the others know more about table etiquette than you do.

Conformity and Investing
When it comes to investing, conformity is often disastrous but that is what most of us indulge in.

Look from your own investing experience or from that of people around you. It may have happened some times in the past that even if you could make a good investing decision on your own, you were led to make bad decisions “just because” you saw your peers making such decisions.

I see this happening a lot these days, when a lot of people are buying stocks “just because” a lot of other people are buying those stocks and are thus pushing the prices up.

So it’s a cycle – stock prices are rising because more people are buying stocks, and more people are buying stocks because stock prices are rising.

Then there are ‘experts’ (the “subjects” planted by brokers and investment bankers) who are appearing on television everyday predicting their next Sensex target – which has now reached 75,000 to 100,000.

Now, because the number of such planted subjects on TV is on a rise, they dress and talk well, and they make us comfortable with their predictions, I see a lot of investors conforming to their views and opinions and falling into the trap of buying even junk businesses.

Although we all know that we’re supposed to “buy low and sell high,” most of us usually have trouble pulling that off because emotions can override pure reason.

After all, even if you logically know what’s best, it’s hard to sell or avoid the market when everyone else is jumping in.

You might think: Are all those people really wrong? The answer is yes. They often are.

Funnily, I see a lot of people these days asking for stock advice on Facebook – mostly on investing groups. Some also seek others’ opinions on the stocks they already own.

Interestingly, these people also get “serious” advice from others.

Now, unlike taking advice on Facebook on a good location for vacation (which I often do), investing often requires doing the opposite of what others are doing.

Conforming to others’ opinions and buying what others are buying and winning at it is a short-term, temporary phenomenon. It is not a successful long-term investing strategy.

If everyone is piling into a certain stock, it’s frequently a good sign that it may have already had its run. And especially when you hear about a stock on business TV, it’s frequently a sign that the advisor is looking for you to buy that stock because he or she is looking to sell (so you are the bigger fool here!)

If you want to use conformity as part of your investing, use it to generate ideas – businesses that are good and thus being talked about.

Don’t blindly buy into “stock stories” because a lot of “planted subjects” want to offload them to you at prices you will hate in the future.

A lot of smart people make stupid money mistakes. I hope you don’t become one of them.

Also Read: Why Smart People Make Big Money Mistakes and How to Correct Them (Gary Belsky)

Print Friendly
About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Nice article and example. Seeing a lot of heartbreak likely to happen when there is a correction.

Trackbacks

  1. […] Read here why smart people like you make stupid money mistakes […]

Speak Your Mind

*