Markets behave rationally most of the time. But at various points in the market cycle, irrational behavior can lead to extremes. Mr. Market is like the typical human being this way: Logical and grounded most of the time, but occasionally way out of bounds.

For investors, these irrational periods are when markets are at their most dangerous. It only takes one major lapse to gravely damage a portfolio. There are two concepts — Groupthink and the Bandwagon Effect — that explain what happens when investors exhibit irrational behavior en masse.

There is also a famous study, first conducted in the 1950s and updated with brain scans half a century later, that shows how peer pressure shapes perception. Not only can peer pressure change what you think, it can change what you see!

Fortunately, there are two powerful techniques for avoiding these pitfalls. We’ll look at the various terms and the psychology study, and then cover the techniques that can help you inoculate.

The term “Groupthink” was popularized through the work of Irving Janis, a research psychologist at Yale University, who published a book on the concept in the early 1970s.

Groupthink is literally when a group of people winds up thinking in the same way, the pull of the group extinguishing independent perspective. This can happen through a desire to promote harmony or a desire to minimize conflict, two sides of the same coin. It can also happen when alternative views are ignored or avoided, or when dissent is frowned on or suppressed.

The Bandwagon Effect has much older origins as a psychology term, dating back to the mid-19th century. In the 1840s, an entertainer named Dan Rice toured the country campaigning for Zachary Taylor, who would go on to become the twelfth president of the United States.

Rice traveled around the country in a bandwagon. As part of the act, he would encourage supporters to “jump on the bandwagon” in support of candidate Taylor. It was viral marketing in its earliest form, 30 years before the light bulb was invented. Because it worked (Taylor won the election), politicians of all stripes started using bandwagons in their campaigns. To “jump on the bandwagon” thus became a cynical description of going along with the crowd.

The most famous peer pressure and conformity study was conducted in 1951 by Solomon Asch, a pioneer of social psychology. For the experiment, Asch would ask eight students to participate in a “perceptual study” — but in reality it was a psychological experiment.

Seven of the eight students Asch used were actors. The idea was to have the actors give a false answer to obvious perceptual questions, and then see if the eighth student — the real participant in the experiment — would change their answer, too.

The group would be shown cards with lines on them like the below (via Wikipedia) and answer questions like, “which of the three lines (A, B or C) corresponds to the reference line?”

reference line experiment

The group was set up so the real student would always answer last, and thus be influenced by the actors. For the first two trials in the experiment, the actors would give the correct answer (which was obvious). For the remainder of the trials, the actors would give a false answer in unison.

Asch found that, in the control group with no actors, the error rate of participants was less than 1%. (The questions were extremely simple.) But when the actors were present, the error rate climbed to nearly 37%, and 75% of all participants gave an incorrect answer — showing they were swayed by the actors — at least once.

When it comes to the old saying “Who are you going to believe, me or your own eyes?” it is clear that, a lot of the time, we wind up trusting our peers more than what we see. But the reality is even stranger than that, as was discovered almost half a century later.

In his excellent book Think Twice, Michael Mauboussin explains how, in the 1990s, a neuroscientist named Gregory Berns did a new version of the Asch experiment, with the added twist of using a functional magnetic resonance imaging (fMRI) machine to scan the brain activity of the participants.

What Berns and his Emory University colleagues discovered was that, as the participants gave their wrong answers to visual puzzles as prompted by confederate peers, the parts of the brain that handle judgment and deliberate action were not activated — only the parts that process visual information.

This meant that actual perception had shifted: The participants who answered wrongly were experiencing an altered visual reality based on manipulated peer input. “Seeing is believing what the group tells you to believe,” Berns concluded.

Berns found something else interesting that confirms the power of Groupthink even more. For the subjects who resisted the temptation to go with the group — the contrarians who stuck with their guns on what they saw, even as their peers said something different — the amygdala brain region showed a spike of activity.

The amygdala is the part of the brain that handles fear and distress. In conditions of sudden danger, the amygdala triggers the “fight or flight” response. This shows that, at the level of the subconscious, going against one’s peers can be a hostile or frightening act. As social beings, we are truly wired to “get along to go along” and “go with the flow.”

So how can investors avoid the pull of Groupthink and the dangers of the Bandwagon Effect? There are two basic techniques — both simple, yet powerful — that can help you avoid these traps.

The first technique is consciously deciding, as an investor, who you self-identify with as a group. Human beings are social by nature, and we all have various groups — professionally, socially, spiritually — that we see ourselves as being a part of.

Meanwhile the majority of investors have poor results and fail to achieve their long-term goals. This is a sad reality, but statistics demonstrate it is true.

On the other hand, there is a small group of winning investors who are successful in markets, and who generate above-average returns from markets while achieving their big goals over time.

If you choose to deliberately self-identify with the winning investor group, and you make a habit of doing this, you will naturally want to think like that group and behave like that group.

This can manifest itself in small things, like asking, “What would winning investors do?” when faced with a decision. It can also manifest itself in big things, like learning specifically where the habits of winning investors diverge from the habits of the crowd, and then consciously embracing those habits.

The second thing you can do is take what Daniel Kahneman and Amos Tversky called “the outside view,” which can help counterbalance the “inside view” that is swayed by emotion and peers. To roughly paraphrase:

  • The “inside view” focuses on personal circumstance, personal details, and personal experience: It is your gut feel about a specific situation at hand, based on anecdotes and evidence and details in front of your nose, and it can also be your desires or what your emotions are telling you.
  • The “outside view” focuses on comparable experiences that other people or groups have had; forms of evidence and data that are not colored by your own experience or gut feel; and an attempt to look at the situation and assess it as a neutral third-party observer, remaining as data-driven as possible.

To adopt the “outside view” is to think like a researcher comparing a data sample to other data samples. It is also like stepping outside of your own shoes: Watching the situation as if you were someone else, to remove the distortions of emotion and peer pressure from the decision-making process.

TradeStops and Ideas by TradeSmith, two of our most powerful software products, can naturally help in both of these areas.

For example: It is easier to self-identify with the winning investor group if you can actually see and emulate what winning investors are doing — and that is the exact rationale (along with mountains of data and backtesting) behind our “Billionaire’s Club” investment screens, which show you what the world’s best investors are doing.

It is also easier to take “the outside view” when you have access to data, presented in a clean and powerful way, that lets you see the state of markets — and your personal portfolio — in a clear and objective light.

Data organized and presented objectively can help make you more rational as an investor, while putting a focus on the right metrics. Following the actions of the best investors in the world, and benefiting from incorporating their decisions into your own portfolio, can then add to investment success. And all of this can lead to greater self-identification with the “winning investor” group as opposed to the crowd, reinforcing a virtuous feedback loop.


Founder, TradeSmith