Practical analysis for investment professionals
29 April 2015

Investment Decisions: How to Avoid Groupthink

Behavioral finance has legitimately called into question the unrealistic assumptions that conventional economics makes about human behavior. It has shown that we are not “rational” but suffer from such behavioral biases as loss-aversion, representativeness, hindsight, anchoring, confirmation, mental accounting, and more.

But does behavioral finance go beyond exposing the weaknesses of conventional economic thinking and offer solutions? For instance, does it provide tools that professional investors can employ to overcome behavioral biases like groupthink or conformity?

The answer, according to behavioral finance coach Paul Craven, ASIP, is yes. Craven explained that groupthink has been a well-documented human bias for some time. He referred to the conformity experiments conducted by researcher Solomon Asch in the 1950s that demonstrated the high degree to which an individual’s own opinions are influenced by those of the majority in a group. Members of an investment committee might suffer from the same tendency and be eager to agree and reluctant to disagree, even when they have ample reason to.

I asked Craven what can be done to address the problem of groupthink in the investment committee context. He said that the chair of the committee has a key role to play in tackling the issue. The chair can create an environment where people are not dissuaded from voicing dissent and are encouraged to play the devil’s advocate.

But isn’t playing the contrarian difficult in practice? After all, by disagreeing, you could be seen as disagreeable. Craven thinks that an investment committee can be smart and formal about how it uses a devil’s advocate. A member of the committee could be assigned the task of researching an issue and coming in prepared to argue the other side of what is being proposed. Craven gave the example of 12 Angry Men, a classic drama, in which one dissenting member of a 12-man jury successfully plays the devil’s advocate, resisting and challenging the consensus of his 11 colleagues until they are all won over.

In addition, Craven clarified, we can all play the devil’s advocate in our own minds, questioning our views and arguments, rather than assuming our reasoning is always sounds. To paraphrase John Maynard Keynes, we should be willing to change our minds when the facts change.

A related measure, said Craven, is keeping a journal of key decisions and recording the rationales behind them instead of relying on memory. A recorded journal allows you to revisit your reasoning on a particular investment decision and will keep you from forgetting and rewriting the past in your mind as time progresses. “Memory is a very bad teacher,” cautioned Craven, and you may not be able to accurately recall why you made a certain decision at a certain time. By going back to the recorded logic behind the decision, an investment committee can judge if it was suffering from groupthink or demonstrated an openness to alternative views.

As Craven put it, these three measures — creating an environment where people can disagree, ensuring the devil’s advocate role is an integral part of the decision-making process, and recording the rationale behind decisions once they are made — are about self-awareness and self-discipline. And that’s what it takes to manage behavioral biases in investment decisions.



For those interested in learning more about behavioral biases in investing and how to correct for them, Craven suggests the following books:

For more on behavioral finance from the Enterprising Investor, see “Rational Is Stupid: Meir Statman on Behavioral Finance.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: ©iStockphoto/jirawatp

About the Author(s)
Usman Hayat, CFA

Usman Hayat writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals," and the literature review, "Islamic Finance: Ethics, Concepts, Practice." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. Previously, he was a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP). He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in Development Economics. His personal interests are reading and hiking.

3 thoughts on “Investment Decisions: How to Avoid Groupthink”

  1. No doubt behavioral finance deserves attention in the investment decision making process as this discussion about the dangers of group think. However, it can be carried too far by the individual investor. Take Gerd Gigerenzer’s argument, in his book recommended above, that because forecasting accuracy of financial experts is miserable, the equal allocation (1/N) rule be employed. Gigerenzer uses the oft repeated behavioral example of Markowitz splitting stocks and bonds 50/50 in his retirement account to avoid regret. Turns out that the father of Modern Portfolio Theory now splits his money among asset classes with risk, return, and portfolio efficiency in mind. I wrote a post about this: Diversifying Your 401(k) / 403(b): Don’t Make Fund Allocations Equal Applied to a 401(k).

  2. Paul Tanner, CFA

    Thanks for reading the article and sharing your comment.

    Yes, like many other things, behavioral finance could be taken too far. But at least in the past, it seems it was “homo economicus” that was taken too far.

    We had one speaker at our annual conference in Frankfurt who suggested that we are much closer to Homer Simpson than we are to homo economicus. You can read more here: Improving Investment Decisions through Better Decision Governance http://annual.cfainstitute.org/2015/04/29/improving-investment-decisions-through-better-decision-governance/

    Regards

    Usman

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