Follow Thy Neighbor (if he’s Buffett)

Today we take a third lesson from Dr. Cialdini and his book Influence: Science and Practice (2nd Ed., HarperCollins, 1988). In the first lesson, we observed the mental mistakes that can follow from perceptual contrast; in the second, we saw how our penchant for unflagging commitment may push us to fall in love with our worst investments.

A third form of influence that can be detrimental to investment performance is social proof. That is, when “we determine what is correct by finding out what other people think is correct” (110). In general, social proof looks sensible; if one doesn’t know what to do, presumably someone else does, so he should follow another’s cue. As Cialdini notes, “as a rule, we will make fewer mistakes by acting in accord with social evidence than by acting contrary to it” (111). Applied to public security markets, social proof entails respecting the market price of a given instrument. What more social proof do you need than the current market-clearing price? The market has spoken. That’s what the business is worth.

Yet, a fairly basic problem lurks here. Out there in the world some actors know what they are doing, but other prominent actors clearly do not (e.g., Lehman, AIG, Madoff). Of course, it is not easy to discern which is which, but it is clear that if we could follow the savvy smarts and disregard the duds, we would be better off (in life and in investing). For example, if we pay particular attention to how Tiger Woods prepares for and plays golf, we’ll do better than if we follow Wide Moat. And we can confirm this because their results consistently diverge over time. Likewise for investing, if we follow the footsteps of Buffett and train our minds to be like his, we will do better than if we were to follow the Beardstown Ladies. While the principle of social proof pushes us to follow any and all leaders, the truth is that we just need to find and follow a good leader.

Of course, in the markets, this assumes that there are better and worse investors, and that we have some tools to reliably differentiate them. Further, it suggests that the successful investor must have the chutzpah to invest contrary to the majority of market participants when they are wrong.

So how does one resist the tendency to join the crowd? For one, the valuation of a given business should take place, as far as possible, before reading news articles, research reports, and blogs. If one can value a business independently, the hooks of social proof will likely not snare him. Second, one must find a way to reliably distinguish the best investors from the crowd–I give my vote to demonstrated, audited, and long-term results. And third, one must not take the consensus view on a security to be decisive. Given our interest in Sears, it is surprising to us that Sears is the most hated stock whose market cap exceeds $250 million. Of course, today’s consensus may ultimately be correct; crowds can be right. But until the cash flow numbers show even greater deterioration, we’re going to stick with our positions.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

Loving the Loser

Have any dead equities to cull from your portfolio? Has the recent market rally thrust you into the role of the butcher? If so, why did you wait, or why are you waiting? Is the delay reasonable and prudent? Must you wait until you get back to even?

As many studies have shown, investors consistently stumble over the same mistakes: they sell their best performing stocks too quickly, they hold their worst performing stocks too long, and they trade too frequently. Today we will take a look at the second mistake—let’s call it “loving the loser.”

Dr. Robert Cialdini, in his Influence: Science and Practice (2nd Ed., HarperCollins, 1988), describes an important psychological principle that may be the culprit for foolish loves—many people find comfort in mindless consistency. In complex societies that demand daily decisions, opportunities for anxiety abound. Patterned behavior and principled thought may alleviate some anxiety, but researchers have observed that this bliss may come at a cost, because opportunistic sales personnel can take advantage of our habits.

For example, Cialdini narrates how toy companies purposely over-market and under-stock the most desirable toys of the holiday season. Knowing that children will nag their parents for the desired treat, and expecting that a few earnest parents will promise and fail to deliver, toy companies can exploit our love of consistency and propel more sales. For if the most desirable toys are out of stock in December, parents will have to buy something else. But the child’s memory will not wane, and the committed parent will return in January or February to make good on his word.

Of course, Cialdini acknowledges that, in the right situations, commitment and consistency are considered virtues, and they should be. The problems occur though when others exploit consistency for their personal gain and the other’s harm. For example, in the Korean War, Chinese interrogators had much more success in getting American POWs to divulge secrets than the Japanese did in WWII. This was because their strategy involved getting the POWs to make seemingly innocuous, or mildly critical, statements about the United States and then commit those words to writing. Over time, the interrogators would ask them to read their words aloud to other POWs, and defend their claims. Over time, in a desire to be consistent with their past proclamations, the POWs began to see themselves as “collaborators,” and their resistance ultimately wilted.

In investing, the desire for consistency may be at the root of loving the loser. Desperately wanting to believe that our initial judgment about a business was correct, we wait until the market price confirms it. Too often though that time never arrives. And as the prospects of a company or industry continue to worsen, our passivity in mindless consistency saps our portfolio returns.

So what should one do? One solution may be that, before every investment, one should put down in writing the primary reasons why the security is undervalued. Then one should also note potential eventualities that may cause the business’ competitive advantage or financial situation to weaken. If one can determine in advance and commit to writing down the relevant factors that may change an investment thesis, our commitment tendency can then work in our favor, rather than against us. Ideally, one would be able to rationally evaluate a business’ prospects at periodic intervals and sell off those investments whose fundamental characteristics have worsened. Yet, given our penchant for mindless consistency, perhaps writing down potential weaknesses in advance may be a highly profitable second best.