Learning from Captain Abrashoff

You don’t have to search too far to find the many parallels that exist in successful businesses. Leadership, Culture, People; all are examples of things we find time and time again in companies that have stood out from their competition and been both shining lights in their industry and excellent companies to have invested in.

Interestingly, its not only in business that we can find these parallels. Success comes in many forms, and one of the more interesting I’ve discovered was a US Naval Ship. What makes it all the more fascinating is that the military is ordinarily viewed as nothing short of autocratic. Leadership is maintained through the hierarchy of rank; orders are to be followed regardless of how lower ranks regard their superiors. In light of this, how did one man take a Guided Missile Destroyer with a divided and troubled crew, that was regarded as the worst in it’s fleet, and turn it into the best ship in the Navy?

'It’s Your Ship’ is the story of Captain D. Michael Abrashoff, the commanding officer of USS Benfold. The book outlines how, by unconventional means, Abrashoff tapped into the latent human potential aboard Benfold to turn it into the ‘gem of the ocean.’

Peter Kaufman, Chairman and CEO of Glenair, (a business whom Charlie Munger classifies as one of the best three operating companies he’s aware of) recommended his outside directors read the book, along with ‘Plain Talk’ and ‘The Carolina Way.’ Of the three, Kaufman noted, ‘Michael Abrashoff had the toughest hand of all - turning the worst performing ship in the Pacific fleet into the best in the Navy, without changing a single crew member.’

And why should that be relevant to us, as investors? Because business is about people. Management and culture matter. Kaufman explains:

‘Despite widely different fields and completely different circumstances in terms of context, the leadership and cultural principles set forth are virtually the same as ours.’

‘In my experience, a high-morale group, properly motivated and incentivised, can out-perform a low-morale peer group by a factor of 5X or more. The typically untapped, latent potential of human beings is stunning, and can be unleashed by the right cultural framework. Unleashing that latent potential, is how, over three decades, Nucor and Glenair have respectively posted seemingly impossible compounded returns of 17% and 18%, with no losses or layoffs.’

The management techniques deployed and subsequent culture created by Abrashoff are prevalent in the world’s best companies we’ve studied. If you’ve read Thomas Peters, ‘In Search of Excellence,’ accredited by Buffett as “A landmark book; without question the most important and useful book on what makes organisations effective, ever written,” you’ll notice the same examples jump out of almost every page; Empowering employees from the depths of the hierarchy to the top, management walking the floors, full transparency, accepting of mistakes, constant innovation, and questioning conventional wisdom are but a few.

Good investments start with good businesses. It’s often the qualitative aspects that determine success. An analysis of the quantitative data on USS Benfold; crew size, diversity, pay, skill level, won’t shed any light on it’s competency. However, an understanding of management philosophy and culture would have given you a strong sense of likely success. It’s a very useful case study, as unlike companies, it’s possible to compare Benfold’s results with it’s identical sister ships over time.

‘First is you could take pairs of companies at a given moment in history that were very similar. They were similar at the point of start-up, the same environment, the same technologies, same changes and same circumstances, and one became a great company and the other one didn’t.” Jim Collins

Initially, the Benford’s crew retention rate was a dismal 28%. Following Abrashoff taking command, all of Benfold’s career sailors re-enlisted for an additional tour, the ships retention rate for the two most critical categories jumped from 28% to 100% and stayed there.

While the Benford’s results were quantitative, in the sense of metrics like re-enlistment rates, combat readiness, re-fuelling efficiency, the means to achieving the results were qualitative. it wasn’t about more pay, a more highly skilled workforce, or more diversity, it was about leadership, motivating others and unleashing human potential.

The Captain challenged Navy procedure to transform a complex organisation. He improvised techniques to build morale and unity. He created a new environment comprising a company of collaborators who flourished in a spirit of relaxed discipline, creativity, humour and pride. In the process, the USS Benfold went on to beat nearly every metric in the Pacific fleet.

Abrashoff noted that the ship he eventually left to his successor, though once divided and troubled, was all a captain could wish for - the gem of the ocean.

Following are some of the gems from the book:

Mission

“In business terms, I viewed Benfold during it’s Persian Gulf deployment as a very productive company with one major customer - my boss, a three-star admiral in command of the Fifth Fleet. To dominate market share, our ship had to top all others in the categories most important to my customer.”

“By getting very good at both inspecting tankers and shooting cruise missiles, Benfold achieved two coveted areas of expertise. The higher-ups were forever fighting over who got to use our services. That should be the goal of any business; Strive to offer high quality at low cost in versatile areas such that customers fight to place their orders.”

Empower People

“Helping people realise their full potential can lead to attaining goals that would be impossible to reach under command-and-control.”

“I found the more control I gave up, the more control I got. In the beginning, people kept asking my permission to do things. Eventually, I told the crew, ‘It’s your ship. You’re responsible for it. Make a decision and see what happens.’ Hence the Benfold watchword was ‘It’s your ship.’ Every sailor felt that Benfold was his or her responsibility. Show me an organization in which employees take ownership, and I will show you one that beats its competitors.”

“The timeless challenge is to help less talented people transcend their limitations.”

“A ship commanded by a micromanager and his or her hierarchy of sub-micromanagers is no breeding ground for individual initiative.”

“I wanted everyone to be involved in the common cause of creating the best ship in the Pacific Fleet.”

“Empowering people means defining the parameters in which people are allowed to operate, and then setting them free.”

“As I saw it, my job was to create the climate that enabled people to unleash their potential. Given the right environment, there are few limits to what people can achieve.”

“Whenever the consequences of a decision had the potential to kill or injure someone, waste taxpayers’ money, or damage the ship, I had to be consulted. Short of those contingencies, the crew was authorised to make their own decisions. Even if decisions were wrong, I would stand by my crew. Hopefully, they would learn from their mistakes. And the more responsibility they were given, the more they learned.”

“When people feel they own an organisation, they perform with greater care and devotion.”

“I am absolutely convinced that with good leadership, freedom does not weaken discipline - it strengthens it. Free people have a powerful incentive not to screw up.”

“Empower your people, and at the same time give them guidelines within which they are allowed to roam.”

“We empowered our young sailors to assume major responsibilities - including giving calm, expert tours of the ships to VIPs so high on the food chain that officers on other ships would probably stutter in their presence.”

“Unlike some leaders, I prefer to build myself up by strengthening others and helping them feel good about their jobs and themselves. When that happens, their work improves, and my own morale leaps.”

“I think [our sister ships] hit a performance ceiling because they didn’t create a supportive climate that encouraged sailors to reach beyond their own expectations. Ultimately, that was Benfold’s edge.”

Value People

“As the new captain of Benfold, I read some exit surveys, interviews conducted by the military to find out why people are leaving. I assumed that low pay would be the first reason, but in fact it was fifth. The top reason was not being treated with respect and dignity; second was being prevented from making an impact on the organisation; third, not being listened to; and, fourth, not being rewarded with more responsibility. Talk about an eye opener. Further research disclosed an unexpected parallel with civilian life. According to a recent survey, low pay is also number five on the list of reasons why private employees jump from one company to another. And the top four reasons are virtually the same. The inescapable conclusion is that, as leaders, we are all doing the same things wrong.”

“As a manager, the one thing you need to steadily send to your people is how important they are to you. In fact, nothing is more important to you.”

“Be there for your people. Find out who they are. Recognise the effects you have on them and how you can make them grow taller.”

“Shortly after I took command of Benfold, I vowed to treat every encounter with every person on the ship as the most important thing at that moment.”

“I said to myself, ‘The only way I can create the right climate is to tell every sailor, in person, that this is the climate I want to create.’ I decided to interview each crew member on the ship so he or she could hear my expectations directly.'“

“In just about every case, my sailors were not born with anything remotely resembling a silver spoon in their mouths. But each and everyone of them was trying to make something meaningful of their lives. Something happened in me as a result of those interview: I came to respect my crew enormously. No longer were they nameless bodies at which I barked orders. I realised they were just like me: They had hopes, dreams, loved ones, and they wanted to believe that what they were doing was important. And they wanted to be treated with respect.”

“Like any workforce, mine appreciated hearing from top management.”

“Keep talking. Tell everyone personally what’s in store for him or her - new goals, new work descriptions, new organisational structure, and yes, job losses, if that’s the case. Explain why the company is making the changes. People can absorb anything if they are not deceived or treated arrogantly.”

“Benfold’s crew lived and worked by the Golden Rule. We trusted that everyone would be treated with dignity and respect, and we expected no less [from anyone]”

“I wanted everyone on the ship to see one another as people and shipmates.”

“Of course, I treated people with the same dignity and respect I expected of them, and I made sure they truly liked their jobs. Freed from top-down-itis, Benfold’s sailors were given responsibilities to make decisions, correct mistakes, and prove to themselves that they were part of a superb crew.”

“Instead of tearing people down to make them into robots, I tried to show them I trusted them and believed in them. Show me a manager who ignores the power of praise, and I will show you a lousy manager. Praise is infinitely more productive than punishment.”

“The commanding officer of a ship is authorised to hand out 15 medals a year. I wanted to err on the side of excess, so in my first year I passed out 115.”

“Newbies are important, treat them well. I greeted each the same way: ‘Welcome .. I appreciate having you on our ship.’ All too often, a gung-ho newcomer runs smack into a poisoned corporate culture that sucks the enthusiasm right out of her. I wanted the newcomers to remain so revved up that they would recharge the batteries of those who no longer felt that way.”

“Try to make the people who work for you feel needed and highly valued. Help them believe in that wonderful old truism, ‘A rising tide lifts all boats.’ With perhaps few exceptions, every organisation’s success is a collective achievement.”

Low End Of The Hierarchy

“Breaking out of our stratified systems to trust the people who work for us, especially those at or near the low end of the hierarchy, was a useful, progressive change.”

“How much brainpower does the Navy - or any organisation, for that matter - waste because those in charge don’t recognise the full potential hiding at the low end of the hierarchy. If we stopped pinning labels on people and stopped treating them as if they were stupid, they would perform better. Why not instead assume everyone is inherently talented, and then spur them to live up to those expectations? Too idealistic? On the contrary, that’s exactly how Benfold became the best damn ship in the Navy.”

Walk the Floors - No Ivory Tower

“The key to being a successful skipper is to see the ship through the eyes of the crew. Only then can you find out what’s really wrong and, in so doing, help the sailors empower themselves to fix it.”

“It seemed to me only prudent for the captain to work hard at seeing the ship through the crew’s eyes. My first step was trying to learn the names of everyone onboard. It wasn’t easy. Try attaching 310 names to 310 faces in one month.”

“I tried to establish a personal relationship with each crew member.”

“Knowing my people well was a huge asset.”

“We used every possible means of communication, including private email to key superiors; daily newsletters for the crew; my own cheerleading for good ideas and walking around the ship chatting.”

“I started eating at least one meal per week on the mess decks with the crew. It paid big dividends; I learned a great deal and got to know people that way, and after a while my officers began taking occasional meals there, too.”

“Many leaders almost never leave their office. Recall how you feel when your boss tells you, ‘Good job.’ Do your people (and yourself) a favour. Say it in person, if you can. Press the flesh. Open yourself. Coldness congeals. Warmth heals. Little things make big successes.”

“Gestures such as joining the enlisted people at cookouts [on the ship’s deck], having lunch once a week with the crew on the mess decks, and making sure visiting VIP’s got to talk to the crew, I tried to show the officers that in human terms we were all in this together, and each person was indispensable to the unity of the Benfold team.”

“When I can build people up, their work improves, and my morale leaps. My approach with the cooks was to walk through the galley just about every other day, telling them how much I appreciated their hard work. And the food got a lot better.”

Reciprocation

“The more I went around meeting sailors, the more they talked to me openly and intelligently. The more I thanked them for hard work, the harder they worked. The payoff in morale was palpable.”

Tone From The Top

“A leader will never accomplish what he or she wants by ordering it done. Real leadership must be done by example, not precept. Whether you like it or not, your people follow your example.”

“Leaders need to understand how profoundly they affect people, how their optimism and pessimism are equally infectious, how directly they set the tone and spirit of everyone around them.”

“It is well known that every leader sets the tone for his or her organisation. Show me an enthusiastic leader, and I will show you an enthusiastic workforce.”

“In desperate times I always grabbed the microphone to communicate. Your people want to hear it from the top that everything is going to be all right after all. In times of peril, people always turn to the guy at the top and look for guidance.”

“When I took command of Benfold, I saw a crew of 310 men and women with untapped talent, untested spirit and unlimited potential. I was determined to be the captain these sailors deserved.”

Purpose

“The whole secret of leading a ship or managing a company is to articulate a common goal that inspires a diverse group of people to work hard together. That’s what my sailors got: a purpose that transformed their lives and made Benfold a composite of an elite school, a lively church, a winning football team, and - best of all - the hottest go-to-ship in the US Navy.”

Generate Unity

“Generate unity. I substituted [the diversity training] for unity training, concentrating on people’s likeness and our common goals rather than differences.”

“If you surround yourself with people exactly like yourself, you run the dangerous risk of groupthink, and no one has creativity to come up with new ideas. The goal is not to create a group of clones, culturally engineered to mimic one another. Rather, unity is about maximising uniqueness and channeling that toward the common goal of the group."

“Unity of purpose is quite achievable, even against heavy odds, and sometimes because of them. We created unity on Benfold.”

Transparency

“Some leaders feel that by keeping people in the dark, they maintain a measure of control. But that is a leader’s folly and an organisation’s failure. Secrecy spawns isolation, not success.”

“As I rose through the ranks in the Navy, I was continually frustrated by how information was stopped at mid-level regions.”

USS Benfold

Common Sense

“The art of leadership lies in simple things - common sense actions that ensure high morale and increase the odds of winning.”

Little Things

“Little things make big successes. Within a couple of months of my taking over, other ship commanders began visiting Benfold to find out how we were getting our sailors to work so well. I was delighted to share all our secrets. They were hardly profound; mainly, we were attentive to people’s feelings and potential. A lot of seemingly small gestures added up to a friendly and supportive atmosphere.”

Innovation & Ideas

“Organisations should reward risk-takers, even if they fall short once in a while. Let them know that promotions and glory go to innovators and pioneers, not to stand-patters who fear controversy and avoid trying to improve anything. To me, that’s the key to keeping an organisation young, vital, growing, and successful. Stasis is death to any organisation. Evolve or die: It’s the law of life.”

“I began with the idea that there is always a better way to do things, and that, contrary to tradition, the crew’s insights might be more profound than even the captain’s. Accordingly, we spent several months analysing every process on the ship. I asked everyone, ‘Is there a better way to do what you do?’. Time after time, the answer is yes, and many of the answers were revelations to me.”

“I decided my job was to listen aggressively and to pick up every good idea the crew had for improving the ship’s operation. After all, the people who do the nuts-and-bolts work on the ship constantly see things that officers don’t.”

“Innovation knows no rank. Good ideas are where you find them - even on the fo’c’sle. My officers were ready to discard a great idea because it came from a lowly enlisted man. Fortunately, I happened to overhear his recommendation. Every leader needs big ears and zero tolerance for stereotypes.”

“In my interviews with the crew, I got feedback in ways I never imagined. After we implemented the lower deck’s ideas on how to improve the way we did business, the ship’s energy began heating up.”

“Innovation and progress are achieved only by those who venture beyond Standard Operating Procedure. You have to think imaginatively, but realistically, about what may lie ahead, and prepare to meet it.”

Creativity

“The management committee always wants to see metrics before they allow you to launch new ideas. Since, by definition, new ideas don’t have metrics, the result is that great ideas tend to be stillborn in most companies today.”

“If I had been forced to chart a course defined by metrics, the creativity we sparked and the changes we achieved probably could not have happened.”

“Rigidity gets in the way of creativity. Instead of salutes, I wanted results, which to me meant achieving combat readiness. The way to accomplish this was not to order it from the top, which is demoralising and squashes initiative. I wanted sailors to open their minds, use their imaginations, and find better ways of doing everything. I wanted officers to understand that ideas and initiative could emerge from the lower deck as well as muscle and obedience.”

Seek and Accept Input

“Let your crew feel free to speak up. I was determined to create a culture where everyone on board felt comfortable enough to say to me, ‘Captain, have you thought of this?’ or ‘Captain, I’m worried about something,’ or even ‘Captain, I think you’re dead wrong and here’s why.’ Yes-people are a cancer in any organisation, and dangerous to boot.’

“After every major decision, event, or maneuver, those involved gathered around my chair on the bridge wing and critiqued it. Even if things had gone well, we still analysed them. Sometimes things go right by accident, and you are left with the dangerous illusion that it was your doing.”

“There was no retribution for any comments. I encouraged people to challenge or criticise anyone in the group; the most junior seaman could criticise the commanding officer.”

“If I was causing [the crew] unnecessary work, then I wanted to know about it. If the crew had a problem with what I was doing, I wanted them to tell me so I could fix it or explain why I had to do things that way, thus expanding my crew’s knowledge of the limitations or requirements imposed on me.”

“When people saw me opening myself to criticism, they opened up themselves. That’s how we made dramatic improvements. People could get inside one another’s mind. They could work together for the best possible Benfold. The result? We never made the same mistake twice, and everyone got to understand the big picture.”

“Even when the reluctance to speak up stems from admiration for the commanding officer’s skill and experience, a climate to question decisions must be created in order to foster double-checking.”

“Make your people feel they can speak freely, no matter what they want to say. If they see that the captain wears no clothes, facts are facts and deserve attention, not retribution.’

Multi-Skill

“In the current squeeze on business costs, many companies have cut back so much that they are only one-deep in critical positions, leaving no margin for error. My goal was to cross-train in every critical area.”

“There is no downside to having employees who know how every division of an organisation functions. The challenge is finding incentives to motivate them to want to do so.”

“Build a strong, deep bench. Cross-training became our mantra. We had young sailors, barely out of boot camp, doing the jobs of first-class petty officers with several hash marks, and doing them well.”

Bad News

“It’s critical that leaders don’t shoot the messenger who brings bad news. A boss who does will not hear about future problems until they are out of hand.”

“Bad news does not improve with age. The longer you wait, the less time your boss has to help you come up with a solution.”

“It’s been my experience in management that while good news makes you feel warm inside, it’s the negative news that makes you learn and helps improve your performance on the job.”

Unconventional

“At first, my unconventional approach to the job evoked fear and undermined authoritarian personality that had been imprinted on the ship. But instead of constantly scrutinising the members of my crew with the presumption they would screw up, I assumed they wanted to do well and be the best.”

“My sailors were free to question conventional wisdom and dream up better ways to do their jobs.”

“As captain, I was charged with enforcing 225 years of accumulated Navy regulations, policies, and procedures. But every last one of those rules was up for negotiation whenever my people came up with a better way of doing things.”

“You will seldom get in trouble for following Standard Operating Procedure. On the other hand, you will rarely get outstanding results. And all too often, SOP is a sop - it distracts people from what’s really important.”

Have Fun

“I focused my leadership efforts on encouraging people to not only find better ways to do their jobs, but also to have fun as they did. And sometimes - actually, a lot of times - I encouraged them to have fun for fun’s sake.”

“When I interviewed my sailors, I asked them not only how we could improve the ship’s performance, but also how we could have fun at work. The responses were amazing.”

“We tried to instill fun in everything we did, especially mundane, repetitive jobs such as loading food aboard the ship.”

“The point was that having fun with your friends creates infinitely more social glue for any organisation than stock options and bonuses will ever provide.”

“The secret to good work? Good play. We were the offbeat ship that wasn’t afraid to loosen up, make the best of what had to be done, and share fun with everyone. Giving our people the freedom to act a little crazy seemed to confirm that we really cared about them.”

“This shows what you can accomplish when you throw formality to the winds and free your people to have a life on your time, which soon becomes the time of their lives. None of this required big money, only imagination and goodwill. On USS Benfold, the secret of good work was good play.”

Accept Mistakes

“I’d like to live in a culture that allows people to candidly acknowledge mistakes and take responsibility. It’s far more useful to focus on making sure the accident never happens again rather than finding someone to blame.”

“Unfortunately, organisations all too often promote only those who have never made a mistake. Show me someone who has never made a mistake, and I will show you someone who is not doing anything to improve your organisation.”

Freedom to Fail

“I worked hard to create a climate that encouraged quixotic pursuits and celebrated freedom to fail.”

Ethics

“I was always careful never to take any ethical shortcuts.”

“I just asked myself this: If what I’m about to do appeared on the front page of the Washington Post tomorrow, would I be proud or embarrassed? If I knew I would be embarrassed, I would not do it. If I’d be proud, I knew I was generally on the right track.”

Bureaucracies

“More often than not, bureaucracies create rules and then forget why they were needed in the first place, or fail to see the reasons for them to no longer exist. When it comes to purging outdated regulations, bureaucracies are sclerotic.”

Continual Learning

“I was determined to turn the ship into an institution of continual learning.”

Competition

“I didn’t consider [the other ships in the fleet] rivals.; I didn’t have any rivals. I was in competition only with myself, to have the best ship we possibly could.”

Conclusion

The characteristics that defined USS Benfold’s success weren’t quantitative. They were qualitative and they were all about people. The physical asset, the ship, was no different to any other in the fleet; it was the people that made all the difference. In a similar fashion, most businesses are defined by their people, too. Investigating the philosophies, values and culture that permeate a business, it’s management and people can provide the clues to it’s ultimate success.

From an investing standpoint I’ve always been cautious of investing in business turnarounds. The base-rates are too low for my liking. Captain Abrashoff’s book got me thinking that just maybe, with the right approach, success in a turnaround can be more easily gauged.

Ultimately, this is a book about humanity and the psychological forces that drive people to work together and achieve. Captain Abrashoff leveraged the levers that drive group output to achieve outstanding performance, regardless of the fact he was on a naval ship. The lessons contained within are not only relevant to the military, they are integral to the success of the any business, and more importantly those that we either are or are wanting to, invest in.

Given our daily interactions with people and society, we can all learn from Captain Abrashoff.

Learning from Robert Cialdini - Part III

Would you consider $300,000 a fair price for a book?

Charlie Munger did, and he even considered it ‘light’ payment, considering the billions he made from the learnings he took from within. That’s how powerful Robert Cialdini’s book, Influence, is. If you’ve got one of the greatest investors of all time happy to spend that much money on his insights, we all should be reading it. And no doubt you’ll be happy to know we don’t have to spend anywhere near that, though, to obtain our own copy.

You may recall that I have already posted on this subject before. And if you noticed that, you’d be right. You may even ask why I waited so long to post this final part. And here’s the answer - we just had the ten year anniversary of Bernie Madoff’s fund’s collapse, and if there was ever a scenario that displayed most if not all of the Influence factors that are explained in Cialdini’s book, then this was it.

Upon that recent anniversary, I found myself engrossed in the SEC report into the greatest ponzi scheme of all time. It’s an incredible story of regulatory incompetence, and that’s incompetence on a level you’d be hard-pressed to beat. As I progressed through the report, I found a smorgasbord of ‘Influencing and Persuasion’ techniques that form the basis of Cialdini’s work, which were apparent as the ponzi scheme developed. The techniques conspired to trip up investors and regulators; Social proof, Scarcity, Authority and Consistency Bias were there in black and white. Had the regulators and investors been mindful of the psychological tripwires, those investors may have been spared capital losses and the fraud would have been detected years, maybe even decades, before.

Once you’ve read Robert Cialdini’s book ‘Influence’ you’ll start to notice the six powerful psychological techniques he unveils in the book everywhere. They each provide a useful principle, like a mental model, that can help explain an individual’s behaviour.

In the previous two posts, we covered off on four of the powerful influences including Consistency and Commitment, Reciprocation, Social Proof and Authority. In this post, we’ll cover off on Liking and Scarcity, two persuasion techniques you’ll see regularly in investment markets.

Scarcity

Let’s start with Scarcity. It should come as no surprise that people want more of those things they can have less of. Humans are challenged emotionally when freedoms are threatened. Retailers use this technique to great effect. Studies show that when supermarkets place limits on the number of items allowed to be purchased on sale, an increasing number of people buy the maximum number allowed. When Adidas releases it’s latest range of shoes, it elevates sales by collaborating with popular designers [social proof] and releasing limited numbers.

“You do much better in this world if you’re selling something, to say “only one to a customer,” and “you have to get in early,” or “you have to know somebody in order to get shares.” And many new issues are sold that way, and it’s very effective. I mean, you know, it’s like those old stories in Russia where there’d be lines, and people would get in them without knowing what they were going to buy when they got to the front of the line. And that’s a very effective selling tool. And it’s one that Wall Street is not unfamiliar with.” Warren Buffett

This tactic is often adopted by promoters in the financial markets. At the 1996 Berkshire meeting, Buffett expanded on the use of the scarcity principle in financial markets.

“Most new offerings are done in a manner where the idea is to have far more demand than supply, and therefore cause people to, maybe, order stock they didn’t even want, and just on the idea that this restricted supply will cause a big jump the first day, whether, you know — you’ve seen Yahoo or a number of other offerings.” Warren Buffett

Bernie Madoff leveraged the power of ‘Scarcity’ by harnessing it’s ‘exclusivity’ and ‘privileged access’ when marketing to potential investors. In the SEC report I mentioned above, the investigation noted one of the Madoff feeder funds, Avellino & Bienes, was not available to everyone… “this was a ‘special’ and exclusive club, with some special investors getting higher returns than others.”

Scarcity is one reason auction prices can sometimes reach unwarranted levels. I’m sure you’ve heard of the winner’s curse, when the auction buyer overpays in the heat of the moment. It’s one of the reasons Berkshire doesn’t participate in auctions of businesses. They like to deal on an exclusive basis. As all businesses are unique, a scarcity element is present. Munger calls this trait the ‘super-deprival-reaction syndrome’ and he’s recognised open-outcry auctions combine some of the worst psychological pitfalls.

“The open-outcry auction is just made to turn the brain into mush: you've got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away... I mean it just absolutely is designed to manipulate people into idiotic behavior.” Charlie Munger

When demand exceeds supply and everyone is chasing the same investment, it’s more likely investors are overpaying. Howard Marks makes a pertinent observation:

“Watch which asset classes they’re holding conferences for and how many people are attending.  Sold-out conferences are a danger sign.”  Howard Marks

In addition to people wanting more of what they don’t have, people feel losses more than they feel gains. This is known as ‘loss aversion’ and it’s one reason most investors fail to cut losing trades. It’s also a reason investors can be wrong-footed when faced with portfolio losses.

Like the other ‘Influence’ principles, the mental short-cuts are innate actions; we make them without thinking. Dan Ariely and Daniel Kahneman provide an evolutionary explanation as to why we experience loss aversion:

“If you think about nature, if you get something good (like you get to eat more food and so on) that’s a good thing, but if you do something bad, you can die. So nature has kind of tuned us to look at the negative side because if you get a bit more food, a bit more money or whatever, there’s a positive expected value but it’s limited. Whereas on the negative side, you can lose a lot. So because of that we just attune more to losses.” Dan Ariely

“Loss aversion - When directly compared or weighted against each other, losses look larger than gains.  This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history.  Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce”  Daniel Kahneman

The Investment Masters, are well aware of loss aversion.

“People are really crazy about minor decrements down. Huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.” Charlie Munger

 “One of prospect theory’s most important contributions to finance is loss aversion, the idea that for most people, losses loom larger than corresponding gains.  The empirical evidence suggests we feel losses about two to two-and-a-half times more than we feel gains. Loss aversion is a clear-cut deviation from expected utility theory.” Michael Mauboussin

 “There is the argument that for virtually any investor, the marginal utility of an extra gain is smaller than the marginal utility of an equal percentage loss.”  Ed Thorp

One method for not letting loss aversion trip you up is to take a longer term view. Remember the stock you own is a business, and the share price will reflect earnings over the long term. Prices don’t always equate with value, so monitor the business performance and understand the stock price contains less useful information. Given short term stock movements are largely random, checking your portfolio less frequently can also help.

"If I knew how to be up every single day, I would do it because up is better than down. The shorter the time frame on marketable securities, the closer you approach 50/50 as to whether it’s going to be up or down." David Abrams

“Well-worn studies confirm the financial utility of long-term viewpoints; however, behavioral psychologists augment the case by showing investors dislike losses two to three times more than they like gains. If short-term gains/losses carry 50/50 odds, then the disdain for losses implies that infrequent monitoring and long-term horizons aide both mental health and financial wealth. In short, Winston Churchill's quip on revenge may aptly apply to myopic investment habits: "Nothing costs more and yields less."  Allan Mecham

“If you don’t check your portfolio every day, you will be spared the angst of watching daily price gyrations; the longer you hold off, the less you will be confronted with volatility and therefore the more attractive your choices seem.  Put differently, the two factors that contribute to an investor’s unwillingness to bear the risks of holding stocks are loss aversion and a frequent evaluation period. Using the medical word for short-sightedness, Thaler and Bernartzi coined the term myopic loss aversion to reflect a combination of loss aversion and the frequency with which an investment is measured… In my opinion, the single greatest obstacle that prevents investors from doing well in the stock market is myopic loss aversion.”  Robert Hagstrom

Liking

The final technique Cialdini recognised was the human trait of liking. People prefer to say yes to those that they like.

“Everybody likes people who like them.” Charlie Munger

Cialdini notes three important factors when it comes to why people will be inclined to ‘like’ others; we like people who are similar to us, we like people who pay us compliments, and we like people who cooperate with us towards mutual goals.

“One very practical consequence of liking/loving tendency is that it acts as a conditioning device that makes the liker or lover tend (1) to ignore faults of, and comply with wishes of, the object of his affection, (2) to favor people, products and actions merely associated with the object of his affection, and (3) to distort other facts to facilitate love.” Charlie Munger

A classic example in investment markets is an analyst who gets close to the company. Analysts can become less objective and focus only on the positives at the expense of potential negatives. Marathon Asset Management are wary of such analysts:

"There is always a danger that an analyst is 'captured' by management. This risk rises for specialist analysts who spend most of their time covering a small handful of companies, whereas a generalist might cover a few hundred. Capture poses the threat that an analyst lands up becoming the mouthpiece of management" Marathon Asset Management

They use the analogy of the ‘Stockholm syndrome’..

“There is also the issue of 'Stockholm syndrome'.. Research analysts are also vulnerable to this and particularly when they get too close to the companies they follow. If an analyst only covers ten or so companies and works for a big influential house, then it is likely the analyst will have a close relationship with the management of the companies. It is often the case that a friendship and a closeness develops whilst analysts also receive significant hospitality from these companies and as a consequence objectivity may be compromised." Marathon Asset Management

And investors can get caught too. It’s one reason some investors prefer not to meet management. Instead they prefer to work through old company reports to see if what management said they would do, they did.

"I typically don't meet management. I don't talk to management. I was in private equity for 15 years. And generally, if you become a CEO of a company you’re a really good salesman, one way or the other, and you're gonna probably spin people. I made a couple of big mistakes when I got involved in situations where I liked people too much. And, I generally like people. So, the way to avoid that is put the filter on that rely on reading transcripts, 10ks, 10qs." Ted Weschler

"Given the availability of so much information on the internet, I'm not so interested in meeting management today.  You can get seduced too easily.  I'm more interested in finding out how a person has behaved in the past.  If I can listen to a few of the CEO's speeches and read the transcripts or earnings calls, that is more important than talking to him.  A smart, dishonest person can fool you, especially when he's talking about his own business." Bruce Berkowitz

“The conclusions I’ve come to about managers have really come about the same way you can make yours. I mean they come about by reading reports rather than any intimate personal knowledge or — and knowing them personally at all. So it — you know, read the proxy statements, see what they think of — see how they treat themselves versus how they treat the shareholders, look at what they have accomplished, considering what the hand was that they were dealt when they took over compared to what is going on in the industry." Warren Buffett

Or it may be that an analyst or expert has had similar views to your own in the past or a track record of success. This can lead one to be less objective and less reliant on the facts than required.

"Avoid the Pied Piper. Just because someone has been right seven times in a row is no guarantee that number eight will work. When he is finally wrong, the size of the herd will be at its maximum - just as it plunges over the cliff and into the sea. As investors walk in lockstep with the guru over the cliff, a new guru who pointed the way correctly (though only a few listened) is thrust to the forefront. When he too falls, investors will again frantically search for a new guru so as to perpetuate the guru loser's game." Bennett Goodspeed

When a CEO wants to be liked by the market, their desire, can lead to poor decision making.

"Having a person running a company to please Wall Street can be really problematic." Jim Chanos

“I admire Amazon founder Jeff Bezos. He has revolutionized the retail industry and has two great qualities: He is patient and persistent, and he doesn’t care to please Wall St.’s quarterly expectations. This last quality is often overlooked but it is seldom found and represents, in my opinion, a true competitive advantage.” Francois Rochon

At times, subordinates can be pressured into making dumb decisions, to keep pleasing the CEO, who themselves want to please Wall Street.

“We have seen really decent people misbehave because they felt that there was a loyalty to their CEO to present certain numbers — to deliver certain numbers — because the CEO went out and made a lot of forecasts about what the company would earn.” Warren Buffett

Corporate Board members are particularly vulnerable to sub-optimal decision making where directors try to be liked. Liking correlates with ongoing director fees.

"I would say that the typical organization is structured so that the CEO's opinions, biases and previous beliefs are reinforced in every possible way.  Staff won't give you any contrary recommendations - they'll just come back with whatever the CEO wants.  And the Board of Directors won't act as a check, so the CEO pretty much gets what he wants." Warren Buffett

"CEO's get very diluted information.  They're told what people believe they want to hear. We tell them the facts.  We call a spade a spade." Richard Perry

Summary

It doesn’t take a massive leap of the imagination to see how understanding the persuasion techniques that Cialdini uncovered can help you in the markets. When you read the above, could you relate the themes to any personal experiences, or even experiences of those people who are close to you? I certainly could. It’s not hard.

Many people have discovered their uses; you don’t have to travel too far from home before you encounter one or more of the six factors. You can see, also, how the Investment Masters themselves have identified with the traits and taken active steps to avoid getting ensnared within the psychological trip wires. Charlie even paid large for the read, and if that man saw the sense of the ideas, then we all should. And that’s good enough for me.

Further Reading:
‘Munger Series: Learning from Robert Cialdini,’ Part I and Part 2
Bloomberg Masters in Business: ‘Robert Cialdini, author of Influence’, 2018

Follow us on Twitter: @mastersinvest

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Factfulness -Learning from Hans Rosling

Facts are important. They are the fundamental truth that allows us to make decisions. They allow us to determine what is right and what is wrong. They help us decipher critical information so we can sift the lies and stories from the actual statistical details, and because of this, they’re very hard to refute. In fact, they’re important to almost everything we do, and never more so than in investing.

Having written the last blog post, ‘Investment Stories vs. Facts’ I happened upon a fabulous interview of Oaktree Capital’s, Howard Marks by Tim Ferris. In the interview, Tim Ferris asked Howard Marks if there were any books he’d recommend. Here’s what he had to say..

“The book I’m working on now is called Factfulness, and basically, it unmasks a lot of misperceptions that people have about the state of the world, and they hold these perceptions generally qualitatively, not based on data, and the author tries to substitute facts for these perceptions. He starts with a list of 13 questions describing the state of the world, and fascinatingly, he gives you the answer to one, and you have to think about the answer to the other 12. The average score on the 12 is two, and he points out that if you flip the coin, you’d get six right. So the average American gets two of the 12 questions right, so not only are they systematically wrong, but they’re wrong in the same direction, which is they always pick the more pessimistic answer when the more optimistic one is true, and so he responds to our bias and tries to overcome the ignorance and the bias by using facts and some great, very communicative graphics. So I would recommend Factfulness, and I love the idea of unmasking biases.”

Surprisingly enough, I already owned the book, and I distinctly remember Microsoft’s Bill Gates praising it. When Bill Gates said this book, “.. is one of the most important books I’ve ever read, an indispensable guide to thinking clearly about the world”, it got my attention.

As Howard Marks suggests, the book highlights the biases that most people carry. And not just Joe Averages either, but groups of Professionals, Nobel Prize laureates and medical researchers. It’s striking to think that people can hold firm to such strong, yet erroneous views.

The books author, the late Hans Rosling, details how the world is getting better, why we don’t notice it and he provides us with some tools for better thinking. There are striking similarities between the approaches to improve one’s thinking and seeing the world as it is, with those commonly espoused by the Investment Masters. The book could easily have been written with an investor in mind, for all great investors are seekers of truth. As Warren Buffett has observed:

“The most important thing in investments is not having a high IQ, thank God. I mean, the important thing is realism and discipline. And you don’t need to be extraordinarily bright to do well in investments, if you are realistic and disciplined.”

And this book will help you with realism …

“This is a book about the world and how it really is. It is also a book about you, and why you (and almost everyone I have ever met) do not see the world as it really is.” Hans Rosling

It’s an easy read with lots of insightful examples. I’ve included some of my favourite quotes below:

“The human brain is the product of millions of years of evolution, we are hard-wired with instincts that helped our ancestors to survive in small groups of hunters and gatherers. Our brains often jump to swift conclusions without much thinking, which used to help us avoid immediate dangers. We are interested in gossip and dramatic stories, which used to be the only source of news and useful information.”

“We need to learn to control our drama intake. Uncontrolled, our appetite for the dramatic goes too far, prevents us from seeing the world as it is, and leads us terribly astray.”

“I want people, when they have been wrong about the world, to feel not embarrassment, but that childlike sense of wonder, and curiosity that I remember from the circus, and that I still get every time I discover I have been wrong; ‘Wow, how is that even possible?’.”

“If you want to convince someone they are suffering from a misconception, it’s very useful to be able to test their opinion against the data.”

“Human beings have a strong dramatic instinct toward binary thinking, a basic urge to divide things into two distinct groups, with nothing but an empty gap in between. We love to dichotomize. Good versus bad. Heroes versus Villains. My country versus the rest.”

“Averages mislead by hiding a spread in a single number.”

“We almost always get a more accurate picture by digging a little deeper and looking not just at averages but at the spread; not just the group all bundled together, but the individuals.”

“The stories of opposites are engaging and provocative and tempting - and very effective for triggering our gap instinct - but they rarely help understanding.”

“What do you need to hunt, capture, and replace misconceptions? Data. You have to show the data and describe the reality behind it.”

“I never trust data 100 percent, and you never should either. There is always some uncertainty.”

“It is easy to be aware of all the bad things happening in the world. It’s harder to know about the good things; billions of improvements that are never reported.”

“We are subjected to never-ending cascades of negative news from across the world: wars, famines, natural disasters, political mistakes, corruptions, budget cuts, diseases, mass layoffs, acts of terror. Journalists who reported flights that didn’t crash or crops that didn’t fail would quickly lose their jobs. Stories about gradual improvements rarely make the front page even when they occur on a dramatic scale and impact millions of people.”

“The news constantly alerts us to bad news in the present. The doom-laden feeling this creates is then intensified by our inability to remember the past; our historical knowledge is rosy and pink and we fail to remember that, one year ago, or tens years ago, or 50 years ago, there was the same same number of terrible events, probably more.”

“When you hear about something terrible, calm yourself by asking, If there had been an equally positive large positive movement, would I have heard about that? Even if there had been hundreds of larger improvements, would have I of heard? Would I ever hear about children who don’t drown? Can I see a decrease in child drownings, or in deaths from tuberculosis, out of my window, or on the news, or in a charity’s publicity material? Keep in mind the positive changes may be more common, but they don’t find you. You need to find them, and if you look at statistics, they’re everywhere.”

“When looking at a stone flying toward you, you can often predict whether it is going to hit you. You need no numbers, no graphs, no spreadsheets. Your eyes and brain extend the trajectory and you move out of the stone’s way. It’s easy to imagine how this automatic visual forecasting skill helped our ancestors survive. And it still helps us survive: when driving a car we constantly predict where other cars will be within the next few seconds. But our straight line intuition is not always a reliable guide to modern life.”

“To understand a phenomenon, we need to make sure we understand the shape of its curve. By assuming we know how a curve continues beyond what we see, we will draw the wrong conclusions and come up with the wrong solutions.”

“When we are afraid we do not see clearly.”

”None of us have enough mental capacity to consume all the information out there. The question is, what part are we processing and how did it get selected? And what part are we ignoring? The kind of information we seem most likely to process is stories; information that sounds dramatic.”

“The media can’t waste time on stories that won’t pass our attention filters.”

“If we are not extremely careful, we come to believe that the unusual is usual; that this is what the world looks like.”

“Of all our dramatic instincts, it seems to be the fear instinct that most strongly influences what information gets selected by news producers and presented to us consumers.”

“If we look at the facts behind the headlines, we can see how the fear instinct systematically distorts what we see of the world.”

“The fear instinct is a terrible guide for understanding the world. It makes us give our attention to the unlikely dangers that we are most afraid of, and neglect what is actually most risky.”

“To control the fear instinct, calculate the risks.”

“It is pretty much a journalists’ professional duty to make any given event, fact or number sound more important than it is.”

“The most important thing you can do to avoid misjudging something’s importance is to avoid lonely numbers. Never, ever leave a number all by itself. Never believe that one number on its own can be meaningful. If you are offered one number, always ask for at least one more. Something to compare it with. Be especially careful about big numbers.”

“Beware of exceptional examples used to make a point about a whole group .. ask whether an opposite example would make you draw the opposite conclusion. If you are happy to conclude that all chemicals are unsafe of the basis of one unsafe chemical, would you be prepared to conclude that all chemicals are safe on the basis of one safe chemical?”

“Beware of vivid examples. Vivid images are easier to recall but they might be the exception rather than the rule.”

“We must try hard not to generalise across incomparable groups. We must try hard to discover the hidden sweeping generalisations in our logic. They are very difficult to discover. But when presented with new evidence, we must always be ready to question our previous assumptions and re-evaluate and admit if we were wrong.”

“Be prepared to update your knowledge. In the social sciences even the most basic knowledge goes off very quickly.. In 1996, a minority of 27 percent supported same-sex marriage. Today that number is 72 percent and rising.”

“A small change every year can translate to huge numbers over decades.”

“Some knowledge goes out of date quickly. Technology, countries, societies, cultures, and regions are constantly changing.”

“Forming your worldview by relying on the media would be like forming your view about me by looking only at a picture of my foot.”

“Being always in favour of or against any particular idea makes you blind to information that doesn’t fit your perspective. This is usually a bad approach if you like to understand reality… Instead constantly test your favourite ideas for weaknesses. Be humble about the extent of your expertise. Be curious about new information that doesn’t fit, and information from other fields. And rather than talking only to people who agree with you, or collecting examples that fit your ideas, see people who contradict you, disagree with you, and put forward different ideas as a great resource for understanding the world."

“When I know, for example, that all the population experts agree that population will stop growing somewhere between 10 billion and 12 billion, then I trust the data. When I know that economists disagree about what causes economic growth, that is extremely useful too, because it tells me I must be careful; probably there is not enough useful data yet, or perhaps there is no simple explanation.”

“Its better to look at the world in lots of different ways.”

“Though we absolutely need numbers to understand the world, we should be highly skeptical about conclusions derived purely from number crunching.”

”Resist blaming any one individual or group of individuals for anything. Because the problem is that when we identify the bad guy, we are done thinking. And it’s almost always more complicated than that.”

“When we are afraid and under time pressure and thinking of worst-case scenarios, we tend to make really stupid decisions. Our ability to think analytically can be overwhelmed by an urge to make quick decisions and take immediate action.”

“The future is always uncertain to some degree. And whenever we talk about the future we should be open and clear about the level of uncertainty involved.”

“While it is truly pointless worrying about something unknown that we can do nothing about, we must also stay curious and alert to new risks, so we can respond to them.”

“Beware of fortune tellers. Any prediction about the future is uncertain. Be wary of predictions that fail to acknowledge that. Insist on a full range of scenarios, never just the best or worst case. Ask how often such predictions have been right before.”

“Most important of all, we should be teaching our children humility and curiosity.”

“Being humble, here, means being aware of how difficult your instincts can make it to get the facts right. It means being realistic about the extent of your knowledge. It means being happy to say “I don’t know.”. It also means, when you do have an opinion, being prepared to change it when you discover new facts.”

“Being curious means being open to new information and actively seeking it out. It means embracing facts that don’t fit your worldview and trying to understand their implications. It means letting your mistakes trigger curiosity instead of embarrassment.”

“What you learn about the world at school will become outdated within 10 or 20 years of graduating. So we must find ways to update adults knowledge too.”

Summary

Everything we do in daily life revolves around our learning. And Rosling believes that what we have learnt in the past clearly has a ‘use-by-date’ attached. Basically that means all our known information can become obsolete. That also means we cannot rest on our laurels and must accept that as humans we can never stop learning. The trap with this is that nowadays we have to sift through all the data out there for the kernels of truth or facts, rather than accept all the information at face value.

There is a wealth of critical truth in all of the above which only reinforces my thinking about facts vs stories. Beware a sample size of one. The media’s professional purpose is to be make something more sensational than it really is. We only hear about the negatives, never the positives. Question the assertions of others; never accept what they say as fact until you have proven it so. And as humans we have a very unhealthy appetite for drama and stories.

I really like Rosling’s opinion on how we are wired the same way we have always been wired - to socially interact and hunt just as our prehistoric ancestors did. And we are still hunting; as humans, or investors, we are constantly seeking new information that will allow us to survive. Whether its factual or not is another matter altogether.

Source:
’Factfulness - Ten Reasons We're Wrong About the World--and Why Things Are Better Than You Think’. Hans Rosling and Anna Rosling Rönnlund - Sceptre.

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Learning from Robert Cialdini - Part II

If you read Part 1 in this series on Robert Cialdini's wonderful book 'Influence', or even the book itself, I hope you've started to notice some of the six key principles of influence all around you. In investment circles, you will witness these mental shortcuts being practiced every day by peers, clients or fellow investors. All of these groups are human beings and because of this, unless we are aware of these things we will practice them ourselves without thinking.

In the last post we discussed the principles of Commitment & Consistency and Reciprocation and how each is relevant to business and investing. We also looked at some methods to ensure they don't detract from investment performance. In this post we'll touch on two of the remaining four principles. You'll notice, like the first two, these principles strike at the heart of investing. They are Social Proof and Authority. Let's consider each and look at some investment analogies.

Social Proof

We are all social animals and we conduct ourselves in a manner that fits in with others. As a general rule, in everyday life we make fewer mistakes by acting in accord with social evidence than contrary to it. I'm sure you've witnessed a situation where someone is looking up at the sky. Not long after, a crowd gathers, doing the same thing. As Charlie Munger has observed "Monkey See, Monkey Do."

"The otherwise complex behaviour of man is much simplified when he thinks and does what he observes to be thought and done around him." Charlie Munger

Cialdini tells the powerful true story of a North American doomsday cult which was infiltrated by a few journalists. The cult leader informed his members that their town was to be flooded, however, they as the chosen ones were going to be saved by aliens arriving by spaceship on a forthcoming date. 

On the 'specific' date at the ‘specified time’, not surprisingly, no spaceship turned up. The group seemed near dissolution. As cracks emerged in the believers’ confidence, the researchers witnessed a pair of remarkable incidents. The cult leader told the members she had received an urgent message from the Guardians stating, “the little group had spread so much light that God had saved the world from destruction." Having previously shunned publicity, the cult leader then at once called the newspaper, to spread the urgent message. The other members followed suit placing calls to media outlets. 

So massive was the commitment to the cult that no other truth was tolerable. The member's previous beliefs should have been destroyed from the physical reality that no spaceship had landed, no spacemen had arrived and no flood had come. In fact, nothing had happened as prophesized. 

There was but one way out of the corner for the group. They had to establish another type of proof for the validity of their beliefs: social proof. The fact the leader was still believing let other members also believe.

Social proof is most powerful when we are uncertain. Cialdini notes "when people are uncertain, they are more likely to use other's actions to decide how they themselves' should act." And the principle of social proof is most powerful when we are observing the behaviour of people just like us. Furthermore, the more people that are doing the same thing, the more we're inclined to believe they must know something we don't.

In ambiguous situations, there is a tendency for everyone to be looking to see what everyone else is doing. This can lead to a phenomenon called 'pluralistic ignorance'; something happens and no one acts; each person decides that since nobody is concerned, nothing is wrong. The inaction of others can be as powerful a guide to action as action itself. 

"Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof." Robert Cialdini

When it comes to investing, Social Proof is one of the most common, powerful and dangerous influences. Perfect information is unattainable in investing and because of it, uncertainty reigns.

"No matter how much research is performed, some information always remains elusive: investors have to live with less than complete information." Seth Karman

It's easy to see why investors are often swayed by the crowd. When prices are rising we look to others behaviour and buy. Conversely when a sell-off ensues, we panic and sell. The tech boom, nifty-fifty mania, and bitcoin are all good examples. More recently, long dated sovereign bond yields went negative around the world. This smacks of 'pluralistic ignorance.'

"When speculation gets rampant, and when you’re getting what I guess Charlie would call 'social proof' — that it’s worked recently — people can get very excited about speculating in markets." Warren Buffett

“The crowd madnesses recur so frequently in human history that they must reflect some deeply rooted trait in human nature. A bull market, for example, will be sweeping along and then something will happen – trivial or important – and first one man will sell and then others will sell and the continuity of thought toward higher prices is broken.” Bernard Baruch

We can overcome the pitfalls of social proof by relying only on the facts and taking the time to think. It is important to recognise that share prices are often a function of the crowd, and crowds are often wrong. In addition, just because a share price hasn't reacted to some news doesn't imply it shouldn't have. 

"We focus on the facts of an investment case and ignore the crowd." Bruce Berkowitz

"You can’t look around for people to agree with you. You can’t look around for people to even know what you’re talking about. You know, you have to think for yourself." Warren Buffett

“It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it.  Yet distancing yourself from the crowd is an essential component of long-term investment success.” Seth Klarman

"You have to think for yourself. It always amazes me how high-IQ people mindlessly imitate. I never get good ideas talking to other people." Warren Buffett

“You will not be right simply because a large number of people momentarily agree with you... You will be right over the course of many transactions, if your hypothesis are correct, your facts are correct, and your reasoning is correct.” Warren Buffett

"A basic ingredient of outstanding common stock management is the ability neither to accept blindly whatever may be the dominant opinion of the financial community at the moment nor to reject the prevailing view just to be contrary for the sake of being contrary. Rather, it is to have more knowledge and to apply better judgement, in thorough evaluation of specific situations, and the moral courage to act 'in opposition to the crowd' when your judgement tells you you are right." Phil Fisher

"Learn how to ignore the examples of others when they are wrong; because few skills are more worth having." Charlie Munger

While acting in concert with the crowd can be disastrous, taking advantage of the crowd can be highly profitable. It's the social-proof aspect of the public markets that creates mis-pricing opportunities for those who have done the work and can think independently. These opportunities don't arise in private markets where business or property owners tend to be less emotional and choose the optimal time to sell their asset.

"Auction driven markets have a great quality that tends to undershoot and overshoot underlying value quite significantly. So for example, if I took a dart and threw it at any stock in the New York Stock exchange and look at the 52 week range on it, there will be something like 70 to 130. If I look at a business that’s for sale and I asked the owner of the business what the selling price is, it’s hardly going to move over the year. Maybe +/- 15% at most. So auction driven markets create opportunity to buy when they are cheap and sometimes to sell when they are overpriced." Mohnish Pabrai

Public market opportunities have a tendency to be contrarian and therefore can make us feel uncomfortable and lonely.

"The ultimately most profitable investment actions are by definition contrarian; you're buying when everyone else is selling (and the price is thus low) or you're selling when everyone else is buying (and the price is high). These actions are lonely and, uncomfortable." Howard Marks

“You have to be willing to have the courage to stand by your convictions and that can be a very lonely place to be at times." Chris Mittleman

Corporate leaders, Wall Street analysts and Investment Committees are not immune from social proof tendencies. In the former, aggressive corporate takeovers, bidding wars, buybacks at market highs, and mis-aligned incentive structures are often implemented because of what others are doing.

"In the highest reaches of business, it is not all uncommon to find leaders who display fellowship akin to that of teenagers. If one oil company foolishly buys a mine, other oil companies often quickly join in buying mines." Charlie Munger

"The herd-like behavior of companies and their managements never loses its power to astound. All to often one company decides that buybacks are the thing to do, then its competitors will play the game too. By the same token, capital raising often appears at the same time among multiple companies in the same industry" Marathon Asset Management

"The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated." Warren Buffett

Wall Street analysts are just as guilty; better to maintain a view consistent with the other analysts than step out on a limb and make a bold contrarian call. When the whole market loves or hates a stock, it's hard to think so many smart people are wrong. Better to raise your price target to where the stock is currently trading.

"Man is extremely uncomfortable with uncertainty. To deal with his discomfort, man tends to create a false sense of security by substituting certainty for uncertainty. It becomes the herd instinct. The irony is that the greater the uncertainty, the greater the similarity of predictions, as the experts 'shout together in the dark'." Bennett Goodspeed

"Too many sell-side analysts whisper in each other's ears, and few want to stick his or her neck out too far." John Neff

“Specialist analysts operate in a cocoon, in which they are overexposed to company management and peer analysts and underexposed to what is going on in the rest of the world. Herding instincts may tend to reinforce similar opinions among peer analysts.” Marathon Asset Management

Authority

You might be surprised to know that we have been trained from birth to acknowledge that obedience to proper authority is right and disobedience is wrong.

"The essential message [of obedience] fills the parental lessons, the school-house rhymes, stories, and songs of our childhood and is carried forward in the legal, military, and political systems we encounter as adults. Notions of submission and loyalty to legitimate rule are accorded much value in each." Robert Cialdini

Our obedience takes place is an automatic fashion with little or no deliberation.

Cialdini provides colourful examples where people make irrational decisions and/or unthinkable mistakes because of some authoritative directive. Authority can come in many forms, it could be clothes [a uniform or even a business suit], a title [ie an 'expert', a 'rated analyst,' a PhD, CFA?], or personal trappings of authority [a nice Wall Street Office with an electronic LED ticker behind?]

I can't tell you the number of times I've seen investors make irrational decisions based on some authority figure's viewpoint. You'll always find some Wall Street expert predicting the market will crash, the USD/Euro/Yen is going to rally/collapse, gold is going to $3,000 etc .. take your pick. Wall Street analysts are paid to act and sound confident in their forecasts. Its worth noting that the Investment Masters are highly skeptical of forecasts.

"I'd advise you to approach the entire subject of forecasts and forecasters with extreme mistrust." Howard Marks

Testing a forecasters' track record from a few years ago can be both enlightening and entertaining.

"Old forecasts are like old news - soon forgotten - and pundits are almost never asked to reconcile what they said with what actually happened." Philip Tetlock

"One of my greatest complaints about forecasters is that they seem to ignore their own records. The amazing thing to me is that these people will go on making predictions with a straight face, and the media will continue to carry them." Howard Marks

“I was recently involved in a situation where projections were a part of the presentation. And I asked that the record of the people who made the projections, their past projections also be presented at the same time. It was a very rude act. Believe me, it proved the point. I mean, it was a joke. So, we’ll leave it at that.” Warren Buffett

And never forget, there is always someone who picked the last few winners. The problem is, next time it's likely to be a different person.

"In both economic forecasting and investment management, it’s worth noting that there’s usually someone who gets it exactly right… but it’s rarely the same person twice." Howard Marks

"Consumers of forecasting will stop being gulled by pundits with good stories and start asking pundits how their past predictions fared - and reject answers that consist of nothing but anecdotes and credentials." Philip Tetlock

“Organizations that take the word of overconfident experts can expect costly consequences … however, optimism is highly valued, socially and in the market; people and firms reward the providers of dangerously misleading information more than they reward truth tellers.” Daniel Kahneman

“People are also attracted to the titles and degrees of academics because finance is not a credential-sanctioned field like, say, medicine is. So the appearance of a Ph.D. stands out. And that creates an intense appeal to academia when making arguments and justifying beliefs – “According to this Harvard study …” or “As Nobel Prize winner so and so showed …” It carries so much weight when other people cite, “Some guy on CNBC from an eponymous firm with a tie and a smile.” A hard reality is that what often matters most in finance will never win a Nobel Prize: Humility and room for error.” Morgan Housel

It's important to get the facts and make up your own mind. Remember, even the world's best investors are rarely right more than 6 out of 10 times. Analysts and Wall Street experts are likely inferior. Don't follow them blindly.

"You will not be right simply because important people agree with you." Warren Buffett

“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos

Authority + Social Proof

Oftentimes the interaction of Authority and Social Proof amplify outcomes. Asset bubbles are a good example.

"Avoid the Pied Piper. Just because someone has been right seven times in a row is no guarantee that number eight will work. When he is finally wrong, the size of the herd will be at its maximum - just as it plunges over the cliff and into the sea. As investors walk in lockstep with the guru over the cliff, a new guru who pointed the way correctly (though only a few listened) is thrust to the forefront. When he too falls, investors will again frantically search for a new guru so as to perpetuate the guru loser's game." Bennett Goodspeed

“Groupthink” frequently causes an individual to capitulate to crowd thinking simply because he or she finds it difficult to believe that such a large group of people could be wrong particularly when an authoritative figure lends his or her stature to the proposition.  The spread of epidemics and information cascades – where a faulty thesis proliferates by word of mouth like a forest fire leaping from tree to tree, without the validity of the original thesis again being contested – further explains the suppression of the constraints of rational and independent thought.” Frank Martin

As is Bernie Madoff's ponzi scheme .. 

"Bernard Madoff showed, thirteen thousand investors and their advisers didn't do elementary due diligence because they thought the other investors must have done it." Ed Thorp

And corporate management disasters... 

"In the ambit of social proof, the outside directors on a corporate board usually display the near ultimate form of inaction. They fail to object to anything much short of an axe murder until some public embarrassment of the board finally causes their intervention." Charlie Munger

"Pressure to meet those numbers any way possible is something all employees feel despite their manager's denials. The non-verbal signals, the phraseology, the tone, the authority figure syndrome, and the implications of what is said count more than good intentions and assumed ethical parameters." Marianne Jennings

"Confrontation at a meeting where one side has authority and the other needs the job can breed strange and unintended responses." Marianne Jennings

It takes courage to think independently, and it takes a lot more of the same to be able to act that way. The concept of Social Proof occurs around us every single day, and being able to run against the tide is something that we know can make us feel uncomfortable and very, very alone. And if you add Cialdini's concept of Authority to the mix, it only makes us feel worse to work against the herd. If someone with a title and a large sense of self-importance with little in the way of track record is offering conviction on an opinion, it is almost impossible for most of us to go the other way. But this is a key difference between the Investment Masters and the rest of us. Courage to take a different path, humility to know when they're wrong and a healthy wariness to forecasters and their crystal balls. 

It's a conscious choice; to blindly follow the loudest voices or the biggest crowds, or to actively choose to go on your own, independent path.

Further Reading:
The Munger Series - ‘Learning From Robert Cialdini - Part I’
The Munger Series - ‘Learnings from Robert Cialdini - Part III’ 

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Overcoming Investment Fears

One of Warren Buffett's most famous sayings is: "To be Successful in the Stock Market, Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.” The challenge for investors is that, as humans, we've evolved from hunters and gatherers and are hardwired to feel fear. In fact, fear is our most basic emotion.

One of the best explanations I've found to describe why this is the case can be found in the insightful book 'Sapiens', by Yuval Noah Harari. Mr Harari explains .. 

“For millions of years, humans hunted smaller creatures and gathered what they could, all the while being hunted by larger predators. It was only 400,000 years ago that several species of man began to hunt large game on a regular basis, and only in the last 100,000 years with the rise of Homo sapiens that man jumped to the top of the food chain.

That spectacular leap from the middle to the top had enormous consequences. Other animals at the top of the pyramid, such as lions and sharks, evolved into that position very gradually, over millions of years. This enabled the ecosystem to develop checks and balances that prevent lions and sharks from wreaking too much havoc. As lions became deadlier, so gazelles evolved to run faster, hyenas to cooperate better, and rhinoceroses to be more bad-tempered. In contrast, humankind ascended to the top so quickly that the ecosystem was not given time to adjust. Moreover, humans themselves failed to adjust. Most top predators of the planet are majestic creatures. Millions of years of domination have filled them with self-confidence. Sapiens by contrast is more like a banana republic dictator. Having so recently been one of the underdogs of the savannah, we are full of fears and anxieties over our position.”

Burdened by fears, it's little wonder the average investor underperforms the stock market. When we are fearful, our decision making is sub-optimal. We do the wrong things at the wrong time.

"Psychologists have persistently shown that pressures, anxieties, tensions and fears seriously degrade our skills as decision makers.” W Morris [1973]

Most investors sell when they are fearful and wait until conditions improve before they re-enter the market. They sell low and buy high.

And it's not easy to make the adjustment required for better investment results. But it's critical if we wish to succeed.

"Fear is overdone concern that prevents investors from taking constructive action when they should." Howard Marks

“Try not to let your emotions affect your judgement. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.” Walter Schloss

"To remain calm and rational in the face of wild fluctuations in stock prices is, beyond the shadow of a doubt, the most significant quality an investor can have or try to have." Francois Rochon

“Emotional mitigation – you’re trying to find some way to mitigate the emotional dimension which is constantly driving people to make incorrect decisions. Data that’s accumulating from behavioural finance substantiates the fact we are, by and large, horribly wired to be objective.” William Browne

"If you have a temperament that when others are fearful you’re going to get scared yourself, you know, you are not going to make a lot of money in securities over time, in all probability." Warren Buffett

The good news is that there are strategies an investor can employ to help overcome investment fears and stay the course for better investment returns. These include:

Know What You Own

When you know what you own, you're far less likely to be influenced by the actions of others and take your cues from the stock price. Imagine yourself standing in your office and seeing a lion on the other side of the glass. If you're like most people, you'd run. But imagine, the prior day you'd accidentally driven your car into the glass at high speed and bounced off. Later you found out it was toughened glass that not even a truck could drive through. With that knowledge in hand, you wouldn't run, no matter how large or aggressive the lion was.

And so it is with stocks; when you have confidence in the underlying business through a detailed assessment of the company, you're far more likely to act rationally when others are fleeing. You won't take price action as conveying news.

“Fear is overcome by clarity.” Bennett Goodspeed

“Knowledge is the antidote to fear.” Ralph Waldo Emerson

You may remember me writing about walking past someone on the street who is looking up, and without thought, or knowledge as to why, many of us will simply follow suit. Basically, in the absence of information, you'll look to others for guidance. Similarly in investing, most investors don't do the work to understand the businesses they own, so it's easy to see how the crowd can over react. They think someone else knows more and so jump onto that bandwagon, causing a negative feedback loop to emerge. The price becomes the news and stocks trade at levels far from what the fundamentals would suggest appropriate.

"[As humans] we imitate without thinking. Especially when many or similar people do it, when we are uncertain, in an unfamiliar environment, in a crowd, lack knowledge, or we suffer from stress or low self esteem." Peter Bevelin

"Be undeterred by fears or hopes based on conjectures, or conclusions based on surmises." Phil Fisher

"If you lack confidence, fear will drive you out at the bottom." John Train

Armed with knowledge you can take advantage of fear.

"We like it when others become fearful of the future. Particularly if they sell shares of companies we own (and would want to increase our ownership) at better prices!" Francois Rochon

"[During scary periods such as major market panics] you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted." Warren Buffett

"Fear leads to selling. And a price that's low because of irrational fear can create an opportunity." Steve Romick

Don't Rely On Tips/Others

When you rely on a tip, you've outsourced the thinking to someone else. And there may not be a lot of thinking or analysis behind that tip. Furthermore, you can't possibly know the right thing to do should the share price start falling.

"In a panic it is not easy to avoid being swept along with the mad tide. [I] emphasize one thing - the importance of getting the facts of a situation free from tips, inside dope, or wishful thinking. In the search for facts I learned that one had to be as unimpassioned as an surgeon. And if one had the facts right, one could stand with confidence against the will or whims of those who were supposed to know best." Bernard Baruch

"A smart man cannot follow another man blindly even though the other man is right, because you cannot have the confidence and act on advice when you do not know what it is based on." William D Gann

"Relying on others’ analysis results in paralysis or panic under volatile conditions." Allan Mechum

Do Your Own Work

"There is an advantage to gathering your own information and making decisions based on facts that you have gathered yourself. Investing is more of an emotional than intellectual exercise, and it becomes very hard to stay on an even keel and to make rational, unbiased judgements if you’re making them based on someone else’s information.

"So if my buddy at hedge fund XYZ tells me that such and such company is a great investment, or if you go to any of these conferences where someone really smart comes up and makes a bold case on whatever company, it may seem compelling at first. So you think, “Maybe I’ll go out and buy it.” Then the stock goes down 40% and you get nervous. How much time did that really smart guy who made the original pitch spend thinking about this issue that is pressuring the stock? You don’t know, because you didn’t do your own work.

When you’re lost in the fog, you tend to make bad decisions because you’re scared. That’s why to me, you don’t necessarily have to know more than the next guy to have an informational advantage. But you are most certainly at an informational disadvantage if you haven’t made the effort to gather enough information to make an informed decision." John Harris

"Doing the analysis yourself gives you the confidence buying securities when a lot of the external factors are negative. It gives you something to hang your hat on." Peter Cundill

Acknowledge Markets will be Volatile

"We are always psychologically ready for recessions or market corrections." Francois Rochon

Buy Value / Seek a Margin of Safety

When you buy stocks based on value criteria and buy with a margin of safety you're more likely to have the confidence to hold on should markets turn down. By having an estimate of the value of the underlying businesses you own you have something to anchor to while others sell in despair.

Furthermore, stocks bought with a large margin of safety are more likely to hold up in difficult investment environments.

"You might want to give some thought to how you'll fare if the future doesn't oblige. In short, what is it that makes outcomes tolerable even when the future doesn't live up to your expectations? The answer is margin for error." Howard Marks

Buy Quality Companies

If you buy quality companies, those with good balance sheets, enduring competitive advantages and strong management, you can be more confident that the business will endure.

"People don't believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50 year flood, which is what 2008 was, and live to take advantage of it." Jeffrey Ubben

Take the Time to Think

It's natural for humans to act on emotion, without thinking. It's hardwired into our DNA. The world's best investors however have developed the ability to detach from their emotions and make good decisions. Before investing, try and consider what could go wrong.

When acting on an investment, take the time to consider whether you may be over-reacting to market noise. When a stock price falls in relation to stock specific news, its important to consider the implications of the news on the company's earnings over the long term. I've seen plenty of examples where a small earnings miss wipes hundreds of millions off a stock's market capitalization, which is many multiples of the implicit value of the miss. Just sitting back and considering whether that makes sense is a worthwhile exercise.

"'If noise behind the bush, then run'. It is a natural tendency to act on impulse - to use emotions before reason. The behavior that was critical for survival and reproduction in our evolutionary history still applies today." Peter Bevelin

Focus on the Facts Not the Story

“We must focus on facts – as Dragnet fans will recall, “Just the facts.” Stories usually have an emotional content, hence they appeal to the X-system – the quick and dirty way of thinking. If you want to use the more logical system of thought (the C-system), then you must focus on the facts. Generally, facts are emotionally cold, and thus will pass from the X-system to the C-system.” James Montier

Recognize the Crowd Might Be Wrong

If you maintain a contrarian mindset, and start with the premise that most investors do the wrong thing at the wrong time, you are less likely to be panicked and act on emotion when others do. That's not to say, you should blindly buy when others are selling or selling when others are buying; the facts must determine that.

"When the price of a stock can be influenced by a 'herd' on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical." Warren Buffett

"None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." Warren Buffett

Test Investment Ideas / Understand the Counter Arguments

Testing your investment thesis and seeking out and considering contrarian views can give you confidence to hold positions you may otherwise look to sell.

“I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.” Charlie Munger

Diversify / Size you Positions

It's inevitable as an investor that some investments won't work out as you expected. That's an unfortunate fact of life. But by ensuring your portfolio holds a collection of securities across a diverse cross section of industries, and maintaining position sizes that are appropriate, will help you maintain a rational viewpoint should a specific event impact those securities. 

"The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment and experience" Steve Clark

"You want to limit your size in any position so that fear does not become the prevailing instinct guiding your judgment." Joe Vidich

Plan Ahead

It is at the height of fear when we are most likely to act on emotion. Having a plan ahead of time which has been developed when you are in an unemotional state, will improve your investment results. 

"[Investors should] prepare and pre-commit. We should do our investment research when we are in a cold, rational state - and when nothing much is happening in the markets - and then-pre-commit to following our own analysis and prepared action steps." James Montier

“When we go into a stock, one of the things we ask ourselves once we’ve decide to buy is ‘what will make us wrong.’ We try and decide in advance how strong the investment case is and when will we know that we are wrong. One of the things we have learnt over the years is that you don’t let the stock price tell you if you are wrong. The stock price might tell you something is going to go wrong, but the stock price by itself doesn’t contain any information, especially in this environment when everything is algorithmic and where prices are being marked against each other every day.” Bill Miller

Be Disciplined

“[You must] have the discipline to stay with your strategy when the market tests your confidence, as it inevitably will.” Leon Levy

"At the time of maximum pain, you need to maintain your discipline.” Lee Ainslie

"In my view, the best tools for dealing with volatility are preparation, intellectual humility, and the discipline to stick with ideas that are right in your wheelhouse." Allan Mecham

Remember you own a piece of a Business

"I think that whenever you go through a period of poor performance or sharp declines, you have to remind yourself that you own a real business, and over time, business results drive returns. You also need to instill a certain level of humility, which allows to re-assessing assumptions to identify mistakes. I fall back on those two ideas to help me make rational decisions in times of distress." Allan Mecham

Focus on Earnings 

It's important to recognize share prices can be volatile and that from time to time are unlikely to reflect the true underlying value of the business. By recognising shares are the fractional ownership of a business and focusing on the company's earnings as opposed to the share price, you are more likely to hold onto long-term winners. Provided the earnings are improving, there are no structural issues and the stock is reasonably priced, over time the price will reflect the fundamentals of the business as opposed to the emotions of the market.

"I know that stocks represent fractional ownership in businesses and that, over time, the stock market will reflect their true intrinsic values. And crises bring worries and fears that make many investors forget that simple fact." Francois Rochon

“What’s the cure for either the fear of stocks or the poor behaviour in regard to market volatility? My answer is quite simple: just don’t look at the market in the short run. If your obstacle to good results is your emotions about the ups and downs of the market, build a system that shields you from those emotions.” Francois Rochon

“I think the best way to keep emotions under control is to remain focused on business fundamentals rather than stock price. When we buy a stock, we establish a roadmap for how we expect the business fundamentals to progress. If the fundamentals are meeting our expectations but the stock has declined, we often use that as an opportunity to add to our position.” Bill Nygren

Maintain A Long Term View

The majority of the Investment Masters recognize successful investing is a long term game. In the short term prices can swing wildly. While the stock market has delivered 10%pa returns on average over the last century, the range of annual returns have been highly random. It pays to focus on the future; will the companies products continue to be demanded? Is there a long runway to growth? Is management capable? Is the company likely to be earning more in 5 years?

Avoid Leverage

"There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions." Warren Buffett

Be Optimistic

In times of extreme market stress, it pays to remember human ingenuity and the long term resilience of the developed world. Simply changing the environment such as taking a stroll outside and away from your desk, can help you think clearer. You're likely to find that not a lot has changed. People outside the confines of the financial markets will be doing what they were doing the day before.

"Since 1945, there have been 11 recessions. Four times, the stock market dropped by more than 40%. And crises have one thing in common: they all ended!" Francois Rochion

"An unwavering confidence in human potential in the long term stands as a lighthouse guiding us towards our destination in the investing world—particularly when the storms are raging.” Francois Rochon

Summary

None of the above, implies that acting when fearful is the wrong strategy. But the acting must be based on sound, rational and unemotional analysis, and you quite simply can't do that if you're afraid, and you certainly can't do that if the herd is afraid and you're blindly following them. And despite this, you will also not always be right, regardless of how well you plan and think and prepare - and you will still require humility to accept this on occasion.

Fear and emotions are the great undoers - allow them to control you and the outcomes will be less than ideal. 

I think Buffett said it best: "To be Successful in the Stock Market, Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”

Further suggested reading:
Investment Masters Class Tutorial - Weak Market, Pessimism, Uncertainty & Panic
Giverny Capital - [Francois Rochon] 2008 Letter 'The Opportunity of a Generation'

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Uncertainty and Panic

You've no doubt recognised that human psychology is a dominating factor when it comes to a company's share price and the market in general. Key to this, of course, is both our own and the collective participants' confidence in that market and our desire that stocks will always go up in price.

Unfortunately you don't have to scratch too deeply into history to see the effect on individual stocks, sectors and the market when that confidence is shaken. At those times, stock prices plummet and we are surrounded by uncertainty. And as naturally as you expect the sun to rise in the east each day, panic follows closely on its heels.

People prefer certainty. Certainty comes when Mr Market is playing ball, the market indices are invariably gaining in value, and our share portfolios are producing great returns. The longer this happens, the greater our certainty will be that it will continue. People feel comfortable, assured, confident in their beliefs that things are going according to plan. It is in these times that people also often delude themselves into thinking they are great investors. "Look at my returns! They speak for themselves!"

Reality often bites hard, however, when Mr Market decides, for whatever reason to stop playing ball. In these situations, those same people have their confidence shaken; uncertainty reigns and many will find it hard to see a way out of the mess. It is quite often that in their desperation they will look to others to see what they are doing, and end up invariably following the crowd. Unfortunately, most of that same group of people are panicking themselves. It only takes one stone to start an avalanche, and the sad fact of the matter is that the crowd doesn't necessarily know any better. 

“In general, when we are unsure of ourselves, when the situation is unclear or ambiguous, when uncertainty reigns, we are most likely to look to and accept the actions of others as correct.” Robert Cialdini

“Psychologists have demonstrated that the vaguer and more complex a situation, the more we rely on other people, both for clarification and as touchstones for our own views. This helps us reduce our uncertainty toward our own beliefs.” David Dreman

“When people are free to do as they please they usually imitate each other. We are social animals, influenced by what we see other people doing and believing. We believe others know more than we do.. We avoid what others avoid. We imitate without thinking. Especially when many or similar people do it, when we are uncertain, in an unfamiliar environment, in a crowd, lack knowledge, or if we suffer from stress or low self-esteem.” Peter Bevelin

"Man is extremely uncomfortable with uncertainty. To deal with his discomfort, man tends to create a false sense of security by substituting certainty for uncertainty. It becomes the herd instinct." Bennett Goodspeed

It is in our very nature to follow others and we often do it unconsciously. Have you ever walked past someone, or even a group of people on the street, who are all looking up at something and stopped to look for yourself? Sometimes we don't even stop to think before we imitate others.

“First, we seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof.” Robert Cialdini

It is also human nature to place more weight on stories and anecdotes than statistical data. People's inferences and behaviour are much more influenced by vivid, concrete information, than by pallid and abstract propositions of substantially greater probative and evidential value.

In the book 'Human Inference: Strategies and Shortcomings of Social Judgement', Richard Nesbitt and Lee Ross define vivid information as information that is likely to attract and hold our attention to the extent it is (a) emotionally interesting, (b) concrete and image-provoking, and (c) proximate in a sensory, temporal or spatial way - characteristics that should be familiar to every investor! 

The authors note the emotional interest of an event is influenced by the degree to which it affects the participants' needs, desires, motives and values. They conclude that "the most disconcerting implications of the principle that information is weighed in proportion to its vividness is that certain types of highly probative information will have little effect on inferences merely because they are pallid. Aggregated, statistical, data-summary information is often particularly probative, but it is also likely to lack concreteness and emotional interest." 

Is it any wonder people panic when they read headlines predicting a market crash, they see and hear of other people losing money and selling or they read of a company's recent problems - all without considering the probability that the information has value or the company's problems will be resolved.

“In a crisis, carefully analyse the reasons put forward to support lower stock prices – more often than not they will disintegrate under scrutiny.” David Dreman

When people panic, the shares price often becomes the 'news'. Other investors assume those selling know more than they do and decide to sell. A self-reinforcing cycle begins where selling begets more selling. 

More often than not however, when everyone is aware of a risk, it is already reflected in the market or stock price. 

"As a general observation, markets tend to over-discount the uncertainty related to identified risks. Conversely, markets tend to under-discount risks that have not yet been expressly identified." Jamie Mai

Having a solid understanding of what you own is a strong countervailing force against the crowd. In a market correction, investors who have no clue as to why they own stocks [outside of 'because they have/and will continue to go up'] or what the intrinsic value of the stocks they own are, use price as their guide in decision making. They have no anchor upon which to assess the correct price for a stock. These investors sell in a non-discriminatory manner with no reference to value.

With the increasing popularity of ETF's and Index Funds it's likely even more investors in the future will be basing their decisions on the movement of 'market prices' as opposed to company fundamentals. If you've bought a biotech ETF for example, and have no idea of its composition or the underlying value of the constituent portfolio, how can you possibly know what the right price is to buy, hold or sell? It's no wonder, the CDO market went 'no bid' at the height of the Global Financial Crisis - investors had no idea about the worth of the underlying assets sitting in the CDO's, let alone the CDO's squared or cubed!

“One way to think about panic is a general, nonspecific response to a poorly understood particular and specific problem. As in the fight or flight reflex, sometimes this response is helpful, and sometimes it isn’t.” Andy Redleaf

“In a situation characterised by uncertainty, said Keynes, our knowledge is based on a 'flimsy foundation' and is 'subject to sudden and violent changes.'” Frank Martin

“Panic is provoked by information failure.. Ignorance is the father of panic. Ignorance makes for credulous and overconfident buyers on the way up. But it really takes over on the way down when investors suddenly realize they have not a clue what they own.” Andy Redleaf

We all know that the worst times to make decisions are when we are stressed or emotional. Panic and uncertainty are both emotions that will inhibit our ability to rationalise a problem. Those people who say they make great decisions when stressed or otherwise emotional are lacking in fundamental self-awareness. Because people tend to follow others in times of panic, the crowd makes dumb decisions. So they all make dumb decisions. When there is panic and uncertainty in the market, ordinarily it is the time to BUY stocks, not sell them. 

“The best bargains arise when there is fear and uncertainty.” David Marcus

“Uncertainty is actually the friend of the buyer of long-term values.” Warren Buffett

“We do not believe in certainty (and anyhow it would be useless as the market would recognize it) and in contrast we like uncertainty (‘debate’) as it scares too many and too much.” James Anderson

“Maximum panic usually coincides with minimum prices.” Howard Marks

“To sell in a panic is not a winning strategy." Francois Rochon

"If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether." Peter Lynch

It's important in these situations to remain rational, and to always remember that the crowd is often doing the wrong thing.

“Losing your perspective in the midst of a market panic is equivalent to losing your money in that market.” Jim Rogers

"There's nothing wrong with worrying and re-examining, but a manager must have the inner poise and toughness not to panic mentally." Barton Biggs

“Another valuable investment secret is that the owners of sound securities should never panic and unload their holdings when prices skid. Countless individuals have panicked during slumps, selling out when their stocks fell a few points, only to find that before long the prices were once more rising.” J Paul Getty

If you've been part of the panic and sold out of your positions because of it, by the time the uncertainty has been resolved you will have largely missed the opportunity.

“High uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.” Seth Klarman

“The uncertainty is what creates the opportunity. It’s the fact that nobody knows whats going on. So our view is things will be fine, it’s going to get a little bit worse but you want to take advantage of that when there is great uncertainty. Everyone whose nervous wants out so you can take advantage of that fact.” Marc Lasry

"If you wait for problems to disappear before investing in stocks, you'll never commit - or earn - penny." Ralph Wanger

"Until results surface, few investors can muster the courage to buy down-and-out stocks that evoke blank stares more often than envy. Once results become visible, the opportunities usually have passed." John Neff

“Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell.” David Dreman

Markets have a tendency to correct themselves after a panicked situation. At the bottom, 'the bears have no shares.'

“A panic may bring a temporary collapse in the market price of an investment, but the stock is bound to recover if the company meets a genuine need and is under good management.” Bernard Baruch

“Declining stock prices can ultimately cause people to panic and sell. But the moment they join the panic and sell stock, they also relieve the cause of their fears and become potential buyers. The act of selling removes the anxiety, restores equanimity, and gives them the cash to buy.” Leon Levy

"Even though bad things happen to companies, industries, even the economy as a whole for a time, somehow society as a whole still moves forward. Problems usually get solved. Recessions end. Somehow the country stumbles on and companies continue to make a profit." Ralph Wanger

Understanding the psychology of crowds can provide an edge by giving you the confidence to step apart from the crowd.

"With a little help from an obscure Frenchman [Gustav Le Bon], years ago I concluded that investment success is more likely to come to those who have some clue about the counter-intuitive way that the thought processes and subsequent behaviors of crowds differ from individuals in isolation. Individuals who submit to the will of a crowd are effectively hypnotized, and behaviours become emotional, impulsive, and difficult to terminate." Frank Martin

“It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success.” Seth Klarman

If you have done the work to understand you're own and crowd psychology, understand the companies that you own and their underlying values, you should embrace uncertainty. It is at these times that opportunities present themselves for the long-term investor.

"I came across a quote from Warren Buffett...and he says: 'We pay a high price for certainty.' In other words, when people are confident, asset prices escalate. That's a bad time to invest. The confident times feel like a good time to invest, but people who want to buy bargains should prefer uncertainty." Howard Marks

"You know the prose: "Maintain buying reserves until current uncertainties are resolved," etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values." Warren Buffett

“It turns out that I've made some of my best purchases during crises” Francois Rochon

"Where there is panic, there is also opportunity." John Neff

“We have usually made our best purchases when apprehension about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.” Warren Buffett

A friend of mine has a saying. "When you're at work, leave your religion, politics and emotions at home. If you're a lawyer, then leave your conscience." Uncertainty, more than anything, creates panic. And following the crowd in a panic is an emotional response. If you know your market and the value of your stocks, then you need not panic and jump on the herd's bandwagon. Opportunity lies within these situations and letting uncertainty and emotions run their course will ensure you miss it every time.

Invest Scared

The stock market has a long history of humbling investors. The Investment Masters understand the need for humility. Ordinarily, when investors have had a good run they risk getting over-confident and letting down their guard, only to have the stock market deliver them losses.

Many of the Investment Masters maintain a psychology of fear..

“It is better if you invest scared, if you worry about losing money, if you worry about being wrong, if you worry about being overconfident because these are the things you want to avoid. They should be foremost in your mind.” Howard Marks

“We are big fans of fear, and in investing it is clearly better to be scared than sorry.” Seth Klarman

"I always start from a position of fear. And then when I see something that looks attractive, I start getting greedy.... But I'm always looking at the downside on something first. I mean, if you can't lose money, you're going to make money.." Warren Buffett

“I know that to be successful, I have to be frightened. My biggest hits have always come after I have had a great period and I started to think that I knew something.” Paul Tudor Jones

“Our goal is to maintain that sceptical attitude about how the world is run, that concern bordering on fear for what might happen, but also to remain functional and able to make decisions while maintaining a portfolio.” Paul Singer

"We have a fear all the time. But that's what keeps us going, that's what keeps us focused. People who say 'I have no fear. I'm not afraid of ever failing,' are kidding themselves. It's the fear of failure, of not wanting to fail, that makes people as great as they are. I know that's what pushes me." Henry Kravis

It's impossible for an investor to know everything there is to know about a company, industry or situation. Investors are dealing with incomplete information and changing circumstances.  

“I am always searching for the underlying truth, based on insufficient information.. it’s simply not possible to have a complete understanding of anything. We’re never truly going to get to the bottom of what’s going on inside a company, so we have to make probabilistic inferences.” Guy Spier

“One of the things I do very well investing is, I gather a lot of information but I never know the whole picture. I have a lot of inputs but never everything and I have to make a decision on incomplete information." James Dinan

As an investor it's important to recognise what you know and don't know. Stick within your circle of competence and buy with a margin of safety. Investing scared makes you worry about loss, fear the things you don't know, and prepare for the unexpected.

Were Munger, Dalio and Soros CIA Trained?

I was recently reading about Hertz, the rental car company in which the stock price had been decimated, falling 92% from its highs in 2014. I came across a note titled “How Hertz became the perfect contrarian short in 2014.” The article interviewed Tom Fogarty, an analyst, who had identified Hertz as a short. This was a very contrarian idea at the time given the rental car market was consolidating [from nine to three major competitors], a smart activist investor [Carl Icahn] had just bought a stake and the company was spinning-off a division. At the time of Mr Fogarty's report, of the Wall Street analysts that covered the stock, 8 had buys, 2 had holds and only 1 recommended selling. The average price target was around $118 and it was trading around $109. Today it trades at around $10.

Mr Fogarty noted “This Hertz call isn’t a situation I’d encountered before so I’d guess it’s a pretty unusual situation. I had a mentor who used to say “there’s no silver bullet in investing, you just have to think it through. Every time.” That was sort of preaching to the choir. Given the choice, I prefer to start from first principles and routinely check to make sure conventional wisdom has empirical support." 

Mr Fogerty cited “ The Psychology of Intelligence Analysis’ from the CIA’s website by Richards J. Heuer [CIA Book] as guiding his investment principles. Always interested in finding an edge I printed out a copy. I think Mr Fogarty has stumbled across one of the most useful guides an investment analyst could find on improving one's investment decisions. While the book deals with CIA intelligence analysis, most of the principles are applied by the Investment Masters.

Like intelligence analysts, investment analysts are dealing with incomplete and ambiguous information, often trying to connect the dots in a fluid environment where time is of the essence. The same human biases that impairs CIA agents' decision making process can impair an investment analyst. 

The book could have as easily been written by Munger, Soros, Dalio and Steinhardt. Daniel Kahneman, whose book 'Thinking Fast and Slow' is commonly referenced by the Investment Masters, is quoted throughout the book. There are also many commonalities with the work of Nassim Nicholas Taleb [Black Swan/Fooled by Randomness] and Philip Tetlock [Super-Forecasting]. 

The book highlights that "when analytical judgements are wrong, it usually was not because the information was wrong. It was because an analyst made one or more faulty assumptions that went unchallenged.”

One of my favourite sayings is “Make the assumption there can be no assumptions”. I had it written on a post-it note on my computer monitor through the Financial Crisis which itself had its origins in the mother of all false assumptions, “US house prices won’t fall on a national basis.” 

The book “aims to help intelligence analysts achieve a higher level of performance. It shows how people make judgements based on incomplete and ambiguous information, and it offers simple tools and concepts for improving analytical skills.” If it’s good enough for the CIA, it’s likely to be useful for the average investor.

You can download a copy of the CIA Book for free at their website here..

I've included some of the key points below .. the first quotes are from the CIA Book and following are quotes in italics from the Investment Masters. 

Be a Generalist

CIA: "To the extent that an experienced specialist may be among the last to see what is really happening when events take a new and unexpected turn. When faced with a major paradigm shift, analysts who know the most about a subject have the most to unlearn." 

Bruce Berkowitz: “We’re generalists, but we need to find the non-Wall Street people who have lived and breathed and suffered in the industries and business we’re now looking at.”

Have a Multi-disciplinary mindset

CIA: "If analysts’ understanding of events is greatly influenced by the mind-set or mental model through which they perceive those events, should there not be more research to explore and document the impact of different mental models?" 

Charlie Munger: “For some odd reason, I had an early and extreme multi-disciplinary cast of mind. I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that would really work. Nobody taught me to do that; I was just born with that yen.” 

Focus on Collecting Information that Matters

CIA: "The reaction of the Intelligence Community to many problems is to collect more information, even though analysts in many cases already have more information than they can digest. What analysts need is more truly useful information to help them make good decisions. Or they need a more accurate mental model and better analytical tools to help them sort through, make sense of, and get the most out of the available ambiguous and conflicting information."

David Dreman: “Investment experts continue to be convinced that their major problems could have been handled if only those extra few necessary facts had been available. They thus tend to overload themselves with information, which usually does not improve their decisions but only makes them more confident and more vulnerable to serious errors.” 

Seek out Other Information

CIA: "Relying only on information that is automatically delivered to you will probably not solve all your analytical problems. To do the job right, it will probably be necessary to look elsewhere and dig for more information." 

Phil Fisher: "Reading the printed financial records about a company is never enough to justify an investment. One of the major steps in prudent investment must be to find out about a company's affairs from those who have some direct familiarity with them." Phil Fisher

Julian Robertson: "I think the main thing is management, getting good management, and checking with their competitors, checking with their compatriots, their suppliers, and finding out, really, if they are good."

Ray Dalio: “I dealt with my not knowing by either continuing to gather information until I reached a point I could be confident or by eliminating my exposure to risks of not knowing.” 

Test your Investment Ideas

CIA: "Objectivity is achieved by making basic assumptions and reasoning as explicit as possible so that they can be challenged by others and analysts can, themselves, examine their validity."

Ray Dalio: “I stress tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong.”

Charles Koch: "I have a lot of ideas. Most of them are terrible. But what saved me – well, to the extent I’ve been saved – is that… I want to get people with the best knowledge and insights in each one of those key aspects and get a challenge from them." 

Remain Open Minded

CIA: "People form impressions on the basis of very little information, but once formed, they do not reject or change them unless they obtain rather solid evidence. Analysts might seek to limit the adverse impact of this tendency by suspending judgment for as long as possible as new information is being received."

Seth Klarman: "We strive to eliminate biases in our decision making that could cause us to reject new information or cling to erroneous beliefs." 

Bruce Berkowitz: "Facts change, we change." 

Beware Of Commitment/Confirmation Bias

CIA: "Once an observer thinks he or she knows what is happening, this perception tends to resist change. New data received incrementally can be fit easily into an analyst’s previous image. This perceptual bias is reinforced by organizational pressures favouring consistent interpretation; once the analyst is committed in writing, both the analyst and the organization have a vested interest in maintaining the original assessment."

Warren Buffett: “What the human being is best at doing is interpreting all new information so that prior conclusions remain intact.” 

Todd Combs: "I never liked talking to my limited partners about ideas I had, because you become somewhat wedded to it, it's harder to change your mind over time, you become pre-committed to your positions and so forth. That's always been my stance." 

Analysts Improve with Experience

CIA: "Substantive knowledge and analytical experience determine the store of memories and schemata the analyst draws upon to generate and evaluate hypotheses. The key is not a simple ability to recall facts, but the ability to recall patterns that relate facts to each other and to broader concepts—and to employ procedures that facilitate this process."

Ken Shubin Stein: "This is an accretive business. The longer you do it, the more you learn, the better you get at it because you see more things. We see more cycles, we see more industries, we learn more business models. We learn how more business models fail. And all of us in business tend to get better as we get older." 

Glenn Greenberg: “I have been in the business since 1973, so I have been looking at companies for a long time. There are a lot of things in my head. There are a number of different models of the kinds of business or situations that can work. It may be the local monopoly concept, the low-cost commodity producer concept, the consolidated industry that has come down to a few competitors, a basic essential service that isn’t going to stop growing, or an industry that may be growing too slowly to attract any competition. So, there are a lot of different models.” 

Deal with Change

CIA: "The intelligence analyst, however, must cope with a rapidly changing world."

John Burbank: "Markets change radically, every five years that I've seen. Markets aren't nearly as good at discounting the future as people think."

Stanley Druckenmiller: "Probably one of my greatest assets over the last 30 years is that I’m open-minded and I can change my mind very quickly."

Be Creative

CIA - "New ideas result from the association of old elements in new combinations. Previously remote elements of thought suddenly become associated in a new and useful combination. When the linkage is made, the light dawns. This ability to bring previously unrelated information and ideas together in meaningful ways is what marks the open-minded, imaginative, creative analyst." 

CIA: "Creativity is required to question things that have long been taken for granted."

CIA: "Creativity, in the sense of new and useful ideas, is at least as important in intelligence analysis as in any other human endeavour."

Leon Levy: "If intelligence is the ability to integrate, creativity is the ability to integrate information from seemingly unconnected sources, and a measure of both abilities is necessary for long-term success in the markets." 

Seth Klarman: “We put great emphasis on a consistent investment process that demands enormous creativity, energetic sourcing, outside-the-box thinking, intellectual honesty, and vibrant debate.”

Consider Alternate Hypothesis

CIA: "The simultaneous evaluation of multiple, competing hypotheses permits a more systematic and objective analysis than is possible when an analyst focuses on a single, most-likely explanation or estimate. The simultaneous evaluation of multiple, competing hypotheses entails far greater cognitive strain than examining a single, most-likely hypothesis. Retaining multiple hypotheses in working memory and noting how each item of evidence fits into each hypothesis add up to a formidable cognitive task."

CIA: "Research on hypothesis generation suggests that performance on this task is woefully inadequate. When faced with an analytical problem, people are either unable or simply do not take the time to identify the full range of potential answers. Analytical performance might be significantly enhanced by more deliberate attention to this stage of the analytical process."

CIA: "Exploring alternative hypotheses that have not been seriously considered before often leads an analyst into unexpected and unfamiliar territory."

George Soros: “The financial markets generally are unpredictable. So that one has to have different scenarios... The idea that you can actually predict what's going to happen contradicts my way of looking at the market."

Paul Singer: "What actually happens in markets is never the only scenario that could have taken place. Elliot's portfolio has been designed to maintain stability in a range of different outcomes, some more difficult than what actually occurs at various times in the ebb and flow of markets. Being set up for the broadest scope of market scenarios has been one of the principal reasons for Elliot's high level of stability in almost every period of adversity for the past 38 1/2 years."

Seek to Disprove Hypothesis Not Confirm Them

CIA: "Focus on developing arguments against each hypothesis rather than trying to confirm hypotheses."

Charlie Munger: "Constantly take your own assumptions and try to disprove them."  

Be Alert to Surprises

CIA: "A surprise or two, however small, may be the first clue that your understanding of what is happening requires some adjustment, is at best incomplete, or may be quite wrong."

Leon Levy: "Investors also have to be alert to changes in the market that could change their original assumptions." 

Warren Buffett: "Charlie and I believe that when you find information that contradicts your existing beliefs, you've got a special obligation to look at it - and quickly." 

Seek out Individuals who Disagree

CIA: "Analysts should try to identify alternative models, conceptual frameworks, or interpretations of the data by seeking out individuals who disagree with them rather than those who agree. Most people do not do that very often. It is much more comfortable to talk with people in one’s own office who share the same basic mind-set."

Bill Ackman: “One of the best ways to get confidence in an idea is to find a smart person who has the opposing view and listen to all their arguments. If they have a case that you haven’t considered, then you should get out. But they can also help give you more conviction.” 

Think Backwards

CIA: "One technique for exploring new ground is thinking backwards. As an intellectual exercise, start with an assumption that some event you did not expect has actually occurred. Then, put yourself into the future, looking back to explain how this could have happened."

CIA: "Thinking backwards changes the focus from whether something might happen to how it might happen. Putting yourself into the future creates a different perspective that keeps you from getting anchored in the present. Analysts will often find, to their surprise, that they can construct a quite plausible scenario for an event they had previously thought unlikely. Thinking backwards is particularly helpful for events that have a low probability but very serious consequences should they occur."

Leon Levy: "One of the virtues of envisioning the present from a different time is that it underscores the important role of the intangibles, such as mood and psychology, that govern the way we perceive and interpret the supposedly hard numbers on which investors base their decisions. My attempt to imagine the present as it would look from a different time helps me sort the real from the illusions that blind us to what is before our eyes." 

Charlie Munger: “Invert, always invert” Jacobi said. He knew that it is in the nature of things that many hard problems are best solved when they are addressed backwards.”

Appoint A Devils Advocate

CIA: "A devil’s advocate is someone who defends a minority point of view. He or she may not necessarily agree with that view, but may choose or be assigned to represent it as strenuously as possible. The goal is to expose conflicting interpretations and show how alternative assumptions and images make the world look different."

Lee Ainslie: "I play devil's advocate and make sure the level of analysis has been complete and thorough and that all the relevant resources have been brought to bear." 

Watch out for Unexpected events

CIA: "Analysts should keep a record of unexpected events and think hard about what they might mean, not disregard them or explain them away."

Bill Nygren: "Throughout the time we hold a stock, the analysts will challenge each other as to whether or not our sell target correctly incorporates all the new information we’ve seen subsequent to our purchase."

Leon Levy: "Investors have to be alert to changes in the market that could change their original assumptions." 

Keep Questioning

CIA: "A questioning attitude is a prerequisite to a successful search for new ideas. Any analyst who is confident that he or she already knows the answer, and that this answer has not changed recently, is unlikely to produce innovative or imaginative work."

CIA: "If you find yourself thinking you already know the answer, ask yourself what would cause you to change your mind; then look for that information."

Chris Mittleman: “If you allow yourself to start thinking you’ve got it all figured out, that’s probably the beginning of the end.” 

Consider the Interactions Between the Variables

CIA: "The number of possible relationships between variables grows geometrically as the number of variables increases."

Source: Psychology of Intelligence Analysis, CIA

CIA: "Serious analysis of probability requires identification and assessment of the strength and interaction of the many variables that will determine the outcome of a situation."

Warren Buffett: “Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains.” 

Allan Mecham: "I’m reminded of a study which showed that as the number of variables requiring analysis increase, the odds of success decline, yet the confidence of participants soar due to extensive time and energy invested." 

Marty Whitman: “Based on my own personal experience – both as an investor in recent years and an expert witness in years past – rarely do more than three or four variables really count. Everything else is noise.” 

Understand Probability

CIA: "Most people do not have a good intuitive grasp of probabilistic reasoning."

Charlie Munger: "If you don' t get elementary probability into your repertoire, you go through a long life like a one-legged man in an ass-kicking contest." 

Identify Milestones Ahead of Time for Being Wrong

CIA: "Identify milestones for future observation that may indicate events are taking a different course than expected."

Craig Effron: "When one of my analysts comes up with an idea I say, “First of all, one to ten, how much do you like it?” If it's not at least a seven, I don’t do it. If it’s a nine or a ten I say, “Okay, I want to know right now at what price you’re selling it and at what price you’re admitting you’re wrong.” I want to do this when we are unemotional. Investors have a tendency, and so do I, to marry positions." 

Establish the Implications of being wrong

CIA: "Analyze how sensitive your conclusion is to a few critical items of evidence. Consider the consequences for your analysis if that evidence were wrong, misleading, or subject to a different interpretation."

Warren Buffett: “If we can’t tolerate a possible consequence, remote though it may be, we steer clear of plantings its seeds.” 

Ensure you Evaluate the Evidence

CIA: "Evaluation of evidence is a crucial step in analysis, but what evidence people rely on and how they interpret it are influenced by a variety of extraneous factors. Information presented in vivid and concrete detail often has unwarranted impact, and people tend to disregard abstract or statistical information that may have greater evidential value. We seldom take the absence of evidence into account."

CIA: "Case histories and anecdotes will have greater impact than more informative but abstract aggregate or statistical data."

Barton Biggs: "Be obsessive in making sure your facts are right and that you haven't missed or misunderstood something." 

Avoid Anchoring

CIA: "With the “anchoring” strategy, people pick some natural starting point for a first approximation and then adjust this figure based on the results of additional information or analysis. Typically, they do not adjust the initial judgment enough."

Charlie Munger: “We try and avoid the worst anchoring effect which is always your previous conclusion. We really try and destroy our previous ideas.” 

Study Your Mistakes

CIA - Analysts interested in improving their own performance need to evaluate their past estimates in the light of subsequent developments."

Charlie Munger: “One of the reasons Warren’s so successful is that he is brutal in appraising his own past. He wants to identify mis-thinkings and avoid them in the future.” 

Prepare for the Unexpected

CIA: "Analysts are often reluctant, on their own initiative, to devote time to studying things they do not believe will happen. This usually does not further an analyst’s career, although it can ruin a career when the unexpected does happen."

Seth Klarman: “Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.”

Occasionally Failures Must be Accepted

CIA "Occasional intelligence failures must be expected."

George Soros: “To others, being wrong is a source of shame; to me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.” 

CIA Original Headquarters Building

You can see from the above examples the Investment Masters already implement the key recommendations of the CIA.

Understanding psychology and human biases provides the opportunity for better decision making and better investment results. Having more mental models improves your perception. Getting back to Hertz … Tom Fogarty debunked the assumption that all investments where activists are involved are profitable and that consolidating industries always lead to improved profitability. This opened his eyes to the problems facing Hertz that the market had overlooked. He questioned assumptions in the search for the truth.

As the CIA motto states "And Ye Shall Know the Truth and the Truth Shall Make You Free." – John 8:32 

"In my judgment, all great traders are seekers of truth." Michael Steinhardt

It's time to implement some CIA tactics into your investment process ...

Avoiding GroupThink

"Society teaches us from childhood that it pays to be part of the group and not be too different." Wilfred Trotter

"Groups can bring out the worst as well as the best in man." Irving Janus

Over the years I've witnessed plenty of costly decisions made by corporate boards and investors as a result of poor group decisions.  

A few years ago I was reading an interview with Adam Weiss of Scout Capital who recommended the book "Groupthink" written by Irving Janus, a Yale psychologist, in 1982. I always like to read the books recommended by investors with solid track records of compounding capital.

“Both James [Crichton] and I recently read Groupthink, Irving Janis’ classic study of how small, cohesive groups of very smart people can make really bad decisions, such as getting deeper into Korea, the Bay of Pigs, and Vietnam. The main point is to make sure you have a culture that questions everything and vets out all the alternatives before zeroing in on one of them.” Adam Weiss

Irving Janus defined the term 'groupthink' as "a mode of thinking that people engage in when they are deeply involved in a cohesive group, when the members' striving for unanimity override their motivation to realistically appraise alternative courses of action. Groupthink refers to a deterioration of mental efficiency, reality testing, and moral judgement that results from in-group pressures."

“When smart men and women combine their intellects to presumably optimise a solution, the result tends to be surprisingly counterproductive. Rather than being boosted by brilliance, groupthink has a perversely dilatory effect on collective reasoning.” Frank Martin

Mr Janus notes "Groupthink is conducive to errors in decision-making, and such errors increase the likelihood of a poor outcome.  Often the result is a fiasco, but not always." 

The book recounts the fascinating historical account of the fiascos of Pearl Harbor, the escalation of the Vietnam War, The Bay of Pigs invasion, the invasion of North Korea and the Watergate cover-up. Each of these catastrophic outcomes was a product of a group decision from a small body of government officials and advisers who constituted a cohesive group. Each instance contained the characteristics of gross miscalculation about both the practical and moral consequences of the decisions by a group of intelligent individuals who ignored contrary information and failed to sufficiently consider alternative outcomes.

Understanding 'groupthink' provides a key to better decision making. While the book's case studies relate to political fiascos they have implications for all types of decision making by groups, particularly financial decisions. Whether a group is involved in managing an investment portfolio or choosing an investment manager or a corporate board is considering a major acquisition, capital is at risk.   

With respect to managing a portfolio, many of the Investment Masters acknowledge the limitations of group decision making, and instead prefer to manage capital on a sole basis. 

"It has been my experience that the more power given to the investment specialist and the smaller the influence of the individuals on investment committees, the better the quality of the work accomplished." Phil Fisher

"If no great book or symphony was ever written by committee, no great portfolio has ever been selected by one, either." Peter Lynch

"Like art, portfolio management can rarely be done in teams (or worst in committees). We can add experience but we lose in personal creativity. Like Warren Buffett once said: “My vision of a group decision is to look into a mirror.” Francois Rochon

"If there were such thing as the Laws of Investing, they would have been written by Graham, Buffett and Munger. A small team size (ideally one) would be one of these laws." Mohnish Pabrai

"Investing probably is not played best as a group sport." Leon Levy

Mr Janus identifies eight major symptoms of 'groupthink' which he splits into three types as noted below [I have included references for investment consideration in italics].

Type 1 - Overestimations of the group - its power and morality

1. An illusion of invulnerability, shared by most or all of the members, which creates excessive optimism and encourages extreme risk taking.

A classic case study is the violent collapse of the hedge fund, Long Term Capital Management [LTCM] , in 1998. This fund comprising legendary traders, a former vice chairman of the Federal Reserve and two Nobel prize winning economists, had an aura of invincibility combined with phenomenal risk, which almost led to the downfall of the US financial system.   

With respect to LTCM, Howard Marks noted "Brilliance like pride, often goes before the fall.  Not only is it insufficient to enable those possessing it to control the future, but awe of it can cause people to follow without asking questions they should and without reserving enough for the rainy day that inevitably comes. This is probably the greatest lesson of Long-Term Capital Management"  

A more recent case study is the significant de-rating of Valeant, a US pharmaceutical company with a successful early track record and strong CEO which led the company to undertake ever larger acquisitions and implement aggressive drug pricing strategies, that became its undoing.  

2. An unquestioned belief in the group's inherent morality, inclining the members to ignore the ethical or moral consequences of their decisions.

The late 1990's collapse of Enron and Worldcom provide two examples of unethical corporate behaviour with respect to corporate accounting and fraud. The more recent conduct of the credit ratings agencies and investment banks in the sub-prime mortgage market that contributed to the Global Financial Crisis is likely a consequence of groupthink.

Type 2 - Closed Mindedness

3. Collective efforts to rationalise in order to discount warnings or other information that might lead the members to reconsider their assumptions before they recommit themselves to their past policy decisions.

"I would say that the typical organization is structured so that the CEO's opinions, biases and previous beliefs are reinforced in every possible way. Staffs won't give you any contrary recommendations - they'll just come back with whatever the CEO wants. And the Board of Directors won't act as a check, so the CEO pretty much gets what he wants." Warren Buffett

4. Stereotyped views of enemy leaders as too evil to warrant genuine attempts to negotiate, or as too weak or stupid to counter whatever risky attempts are made to defeat their purposes.

“I try to assume that the guy on the other side of a trade knows at least as much as I do. Let’s say I buy Texaco at $52 and it suddenly goes down to $50. Whoever sold Texaco at $52 had a perception dramatically different to mine. It is incumbent on me to find out what his perception was.” Michael Steinhardt

“In order to invest, we need to have a sizeable analytical edge over the person on the other side of the trade. The market is an impersonal place. When we buy something, we generally do not know who is selling. It would be foolish to assume that our counterparty is uninformed or unsophisticated. In most circumstances, today’s seller has followed the situation longer and more closely than we have, has previously been a buyer, and has now changed his mind to become a seller. Even worse, the counterparty could be a company insider or an informed industry player working at a key supplier, customer or competitor.” David Einhorn

“I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.” Charlie Munger

Type 3 - Pressure Towards Conformity

5. Self-censorship of deviations from the apparent group consensus, reflecting each member's inclination to minimize to himself the importance of his doubts and counter-arguments.

"Independent directors have to be hard-working people who will attend meetings diligently, ask tough questions and challenge management. We're in the process of looking for directors for one of our companies. Someone I asked about a prospect said "He'll be a pain in the ass to management". Within reason, that's what I want to hear. Relaxed attitudes negate the concept of independence. Directors who serve in perpetuity should be looked at. After enough years, they can conclude their loyalty is to management." Howard Marks

"The reality is that neither the decades-old rules regulating investment company directors nor the new rules bearing down on Corporate America foster the election of truly independent directors. In both instances, an individual who is receiving 100% of his income from director fees – and who may wish to enhance his income through election to other boards – is deemed independent. That is nonsense." Warren Buffett

"CEO's get very diluted information. They're told what people believe they want to hear. We tell them the facts. We call a spade a spade" Richard Perry

6. A shared illusion of unanimity concerning judgments conforming to the majority view (partly resulting from self-censorship of deviations, augmented by the false assumption that silence means consent).

"It's equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisers are present and unanimously support his decision (They wouldn't be in the room if they didn't)." Warren Buffett

7. Direct pressure on any member who expresses strong arguments against any of the group's stereotypes, illusions, or commitments, making clear that this type of dissent is contrary to what is expected of all loyal members.

"Whistle-blower Sherrin Watkins has said that questioning CEO Jeff Skilling about the proprietary of the partnerships would have been 'job suicide". CFO Andrew Fastow is said to have cursed at the Enron representatives who negotiated against the partnerships he ran and tried to get one fired." Howard Marks [2002 memo 'Learning from Enron']

8. The emergence of self-appointed members who protect the group from adverse information that might shatter their shared complacency about the effectiveness and morality of their decisions.

Peter Bevelin succinctly described the issues with group decisions in his book 'Seeking Wisdom - From Darwin to Munger'…  "In a group we feel anonymous, which reduces our feelings of responsibility. We can't be blamed. This can lead to over-confident risk behaviour. We may also become impulsive and destructive. Imitation, obedience to authority, and the fear of being different are forces that drive crowds. Groups don't encourage differences of opinion. If a member of a group disagrees, he may seem disloyal. Unanimity is better than independent thought. Individuals in the group reinforce each other into believing that they collectively are right. They focus on favourable consequences and ignore the downside."

Mr Janus offers a number of prescriptions to help avoid groupthink including:

1.  The leader of the policy forming group should assign the role of critical evaluator to each member, encouraging the group to give high priority to airing objections and doubt.

“One of the best ways to get confidence in an idea is to find a smart person who has the opposing view and listen to all their arguments. If they have a case that you haven’t considered, then you should get out. But they can also help give you more conviction.” Bill Ackman

“I stress tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong.” Ray Dalio

2. The leaders should be impartial instead of stating preferences and expectations at the outset.

3. The organisation should routinely set up several independent groups working on the same policy question under a different leader.

4. The policy making group should from time to time divide into two or more subgroups to meet separately and then come together to hammer out their differences.

"These 'social' difficulties argue for outside directors regularly meeting without the CEO - a reform that is being instituted and that I enthusiastically endorse." Warren Buffett

5. Each member of the policy making group should discuss periodically the groups deliberations with trusted associates in his her unit and report back their reactions.

"I have several times leveraged the partners on specific investments because we have so many entrepreneurs and CEO's in our midst with deep domain knowledge. Many times when I have looked at the list and then presented it to one to three of them with my analytics and said to them "Please don't go buy the stock, but could you tell me if I'm thinking about this the right way; What's your take on it or what insight do you have that I may not know?"  Mohnish Pabrai

6. One or more outside experts or qualified colleagues who are not core members of the policy-making group should be invited to each meeting and be encouraged to challenge views of core members.

"I have a lot of ideas. Most of them are terrible. But what saved me – well, to the extent I’ve been saved – is that… I want to get people with the best knowledge and insights in each one of those key aspects and get a challenge from them." Charles Koch

7. At every meeting to evaluate alternatives at least one member should be assigned role of devil's advocate.

"My thought is, if there's no natural sceptic on an investment maybe it would be wise to appoint one to play devil's advocate anyway." Peter Cundill

"I play devil's advocate and make sure the level of analysis has been complete and thorough and that all the relevant resources have been brought to bear." Lee Ainslie

"We’ve also started to assign an “appointed bear” for big positions. This is an insight from one of my favorite books, Groupthink by Irving Janis.. You need to bless someone to take the contrary position because there are a lot of reasons people won’t do it. I think it’s made a big difference in the quality of our discussions."

8. Whenever the policy issue involves relations with a rival nation a sizeable block of time should be spent surveying all warning signals from the rivals and constructing alternative scenarios of the rival's intentions.

"We continually challenge ourselves by asking, "What can go wrong?" with investments we own or consider owning. By playing mental war games against our best ideas we may gain or lose confidence in an initial thesis, or perhaps come to accept that a long-loved holding should be let go. We call this stress testing process "killing the company." Bruce Berkowitz

“The financial markets generally are unpredictable. So that one has to have different scenarios... The idea that you can actually predict what's going to happen contradicts my way of looking at the market." George Soros

"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments." Seth Klarman

"Charlie and I both think about worst case scenarios a lot." Warren Buffett

9. After reaching a preliminary consensus about what seems to be best policy alternative, the policy-making group should hold a 'second chance' meeting at which members are expected to express as vividly as they can all their residual doubts and to rethink the entire issue before making a definitive choice.

"We are very careful not to close ourselves off to opportunities to hear a well- developed counterview on any of our investments. Vibrant debate is part of our internal process; however, there is no substitute for the argument of an investor who has risked real capital on a view that is in opposition to ours. Without fail, this shines a light on the potential soft spots of an investment and causes us to work even harder to bottom-out the critical elements of our own thesis." Jim Mooney

Avoiding Groupthink is a necessary pre-requisite for investment success. Many of the Investment Masters employ strategies to combat the negative effects of groupthink. As Barton Biggs asserts in his excellent essay "Groupthink = Groupstink" that ‘Although there are some groupthink countermeasures, the only real defence against this intellectual cancer is awareness’.   

Further Reading: Investment Masters Class tutorials - Investment Committees, Testing Ideas, Alternative Scenarios, What you Know, Hubris & Humility, Understanding History, Invert, Confirmation Bias, and Checklists.

Sources: 'Groupthink - Psychological Studies of Policy Decisions and Fiascos' by Irving Janus [Yale University].  1982 Houghton Mifflin Company
'Hedge Hogging' by Barton Biggs. 2006 John Wiley and Sons" - see Chapter 12
"Dare to be Great" Memo - 2006 Howard Marks - Oaktree Capital
'The Essays of Warren Buffett' by Laurence Cunningham, 2nd Edition 2008 - see 'Boards and Managers' and 'Acquisition Policy'