Be the Dumber Guys in the Room

Business, most simply, is the practice of persuasion with the aim of making money. And the wise, worldly investors like Charlie Munger have done well in large part because of their familiarity with basic incentives and common methods of persuasion. One of Munger’s favored guides in his study has been Dr. Robert Cialdini, and in particular, his book Influence: Science and Practice, now in its 5th edition [see our previous discussions here, here, and here].

Dr. Cialdini, with Noah Goldstein and Steve Martin, has recently co-authored a shorter, more accessible account of social psychology’s established findings on human persuasion, entitled Yes! 50 Scientifically Proven Ways to Be Persuasive (Free Press, 2008). All told, it offers 50 brief vignettes that describe effective tactics of persuasion. Though the reader will find some reprises from Influence, I found much of interest and use.

For example, the authors describe the danger of being the brightest person in the room, or in one’s field. James Watson and Francis Crick are well-known as the discoverers of the double helix structure of DNA, even though Rosalind Franklin was the most intelligent scientist working on the problem in those days. Presumably like Franklin, Watson and Crick had clearly identified the most important problem to probe, dedicated their minds fully to its pursuit, and were passionate about their work. Yet, their advantage was their collaboration. Whereas the most brilliant tended to work alone, Watson and Crick sought advice and insight from all resources.

And more recently, behavioral scientists Patrick Laughlin and his colleagues have confirmed the value of collaboration, finding that “the approaches and outcomes of groups who cooperate in seeking a solution are not just better than the average member working alone, but are even better than the group’s best problem solver working alone” (100). Multiple minds working together stimulate more creative solutions and command wider knowledge and perspectives. Further, multiple actors can work on specialized tasks, expediting progress and enabling “parallel processing.” However, despite these benefits, Goldstein et al. argue that decisions made completely by committee are “notorious for sub-optimal performance” (101). Hence, their ultimate recommendation is that information be gathered and accessed collectively, but that decisions are made by a leader.

What lessons can we take from this knowledge of our patterned behavior? In investing, collaboration has clearly produced unprecedented returns for the team of Buffett and Munger. Yet, neither is shy in admitting that Buffett makes most of the buying decisions—at times, not even consulting Munger. Practically speaking, as one gathers information about a potential investment, there is a temptation to myopia, particularly if one is initially inclined to buy or sell. Data that confirms our inclination stands bold; disconfirming data melts into the mess. Crucial then is the intentional act of building and weighing the case against the proposed action. For each security one buys, he must achieve equal fluency in the case for selling. And vice versa. Only amid the trial of contending voices can the decisive agent invest intelligently.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

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.

Is Google on Sale?

Google is down nearly 50% from its 52 week high; it hasn’t been this cheap since 2005! Opportunities like this come around only once in a lifetime. Just buy it and lock it away!

Four simple statements. Two factually true, a third which sets a context, and a final to compel you to act. Stepping back though, we—in truth—have no way to predict whether this “opportunity” will come around again, and even if we could predict that it won’t, it may be absolutely foolish to buy it, and even worse to lock it away.

To be frank, I have no idea what Google is worth and no idea what will be their most profitable product in five years, or a decade. What I do know is that the set of statements deployed above have been used for decades and have motivated money to acquire all sorts of lousy speculations.

Why? Because these statements take advantage of a common human foible—we are easily hypnotized by perceptual contrast. Robert Cialdini, in his Influence: Science and Practice (2nd Ed., HarperCollins, 1988), helpfully describes this foible: “there is a principle in human perception, the contrast principle, that affects the way we see the difference between two things that are presented one after another. Simply put, if the second item is fairly different from the first, we will tend to see it as more different than it actually is. So if we lift a light object first and then lift a heavy object, we will estimate the second object to be heavier than if we had lifted it without first lifting the light one” (12).

Retailers have embraced this insight and recognize that shoppers will perceive something as cheaper—and be more likely to buy—if it is obviously marked down from a higher price, than if they were to merely list it at the lower price. Cialdini relays the example of a realtor who initially showed his clients junky, overpriced “setup” properties before the genuine properties, and the realtor found that the contrast really lit up his clients’ eyes. Auto dealers benefit from this foible when they sell expensive options after the final sales price has been set. Compared to the expensive vehicle, the overpriced options seem rather trivial by comparison, and customers are much more likely to purchase them after the buying decision than before.

Going back to the Google pitch, it looks like something similar is going on. It compels us to frame our perceptions using a relatively opaque signal—price. And we conclude that Google today looks relatively cheap. Then, we elect to act based on the second perception that today’s cheap price is good because historically stocks always tend upward. Buy low and sell high.

I would argue that this common line of thinking is a mental error, and perhaps worse, an error dangerous for your financial health. Rather than investing based on a perceived contrast in price signals, better to invest based on a business’ assets, earnings power, competitive advantages, and capital usage. Google may be cheap today, but compared to what? Its historical price? Well, there may be a good reason for that, and if so, the investor should stay away.

To avoid this perceptual error, many successful investors ignore a business’ current and historical price when screening for potential investments. First they assess the business, then value it, and only then will they look to the market to see if it’s available at a fair price. A contrarian approach, but certainly a useful way to avoid being hypnotized by perceptual contrast.

Disclosure: No position