Joining An Investment Club? Watch Out For Groupthink

by Guest Blogger on 2009-06-116

Manshu from OneMint has written this intriguing guest post about an aspect of social psychology called “groupthink”. Sounds like another term for “herd mentality”. While there are many applications of this concept, it appears to have some interesting implications for the world of investing.

What Your Investment Club Should Watch Out For

If you’re in an investment club or are involved in group investing of some sort, you may want to be aware of this phenomenon called “groupthink”.

Irving Janis coined the term – groupthink, which is a concept referring to how smart and intelligent people, when formed into groups, sometimes make horrendous decisions. Here’s how Irving Janis describes this concept:

β€œI use the term groupthink as a quick and easy way to refer to the mode of thinking that persons engage in when concurrence seeking becomes so dominant in a cohesive group that it tends to override the realistic appraisal of alternative courses of action. Groupthink is a term of the same order as the words in the newspeak vocabulary George Orwell used in his dismaying world of 1984. In that context groupthink takes on an invidious connotation. Exactly such a connotation is intended, since the term refers to the deterioration in mental efficiency, reality testing and moral judgments as a result of group pressures.”

While groupthink is a concept that was used to describe closed groups headed by a leader, I believe there’s some peer pressure involved here; I see it also applying to people who aren’t necessarily in a closed group, but who share the same income group, job profile, and so forth.

Don’t Let Groupthink Cramp Your Investment Style

Irving laid out 8 symptoms of groupthink. They seem to account for the behavior of people during wild market swings and business cycles, don’t you think?

1. Invulnerability
Illusions of invulnerability create excessive optimism and encourage risk taking. Group members may believe that nothing can go wrong and may therefore ignore dangers that stare them in the face. A friend who bought real estate funds at the peak, only to see their value go down by over 80%, told me that during the euphoria of the real estate boom, no one ever spoke or thought about things that could go wrong. Nobody seemed concerned about investment risk; there was much less concern about having to manage risk. So, in a situation where no one ever talks about anything negative, it is easy to get into a cocoon and feel that good times will continue to roll forever.

2. Rationalization
Collective rationalization and consensus seeking are hallmarks of groupthink. Again, during the boom, there were countless occasions when I heard about how things were different this time: that home values could never decline so dramatically, or that the dot com bubble is really an exception to how market cycles work. Well, we now know that things are no different this time.

3. Morality
Unquestioned belief in the morality of the group causes members to ignore the consequences of their actions. According to Irving, victims of groupthink ignore the moral or ethical consequences of their decisions. They often don’t talk about the consequences, or they may actually ignore the consequences, especially when everyone else around them does the same thing. I watched a show about the subprime mortgage crisis the other day. It depicted and interviewed lenders who knowingly participated in subprime lending practices, and who allowed their offices to conduct behaviors that were clearly detrimental to consumers who went to them for assistance. These lenders enabled unqualified homebuyers to purchase homes they could not afford. While some felt morally conflicted about these policies, they still felt that it was easier to ignore the problem and to go with their company’s position on the situation rather than to question what was going on (well, their jobs were at stake).

4. Stereotypes
Stereotyping those who are opposed to the group as weak, evil, biased, spiteful, disfigured, impotent, or stupid. Victims of groupthink hold stereotyped views of the people of the opposing camp. Certain situations can foster an “Us vs Them” mentality. Think about those investors who turned more aggressive as the boom escalated. Day traders, highly leveraged investors or anyone who went on margin were at one point making tons of money during the market peak. Everyone else envied their position. Of course, these days we can only be thankful that we’ve missed those “opportunities” and have somehow avoided the dicey predicament many of these “gutsy” investors find themselves in today. But check out some of the stereotyping that goes on among stock market investors: Are market timers foolish or crazy? Are buy and holders patsies for staying put even while their retirement funds evaporated?

5. Pressure
Direct pressure to conform is applied to any “disloyal” member who questions the group. Pressure is one of those contrarian indicators I use to get a feel for the market. When everyone — and I mean everyone, including your neighbors, family, friends, coworkers or random people you meet on the street — are encouraging you to engage in the same activity (e.g. buy certain investments), it’s an indication that something will probably go wrong very soon. During the peak I received a lot of advice on buying stocks and houses — advice that I felt I didn’t need at the time. I found it very difficult to explain to people why I wasn’t in a buying mood: I’d say “the market is peaking, I’m not buying”. And they’d counter: “it can still go higher”. Or they’d tell me “what, are you nuts?”

6. Self Censorship
There’s a self censorship of ideas that deviate from the apparent group consensus. A system may become vulnerable to losing its checks and balances once it begins working a little too well. Sometimes things are progressing so well that people begin ignoring the flaws in the set up or process; eventually, people block any misgivings, questions and concerns they have and decide to “join in” and become part of the process. They jump on the bandwagon and think to themselves “if you can’t beat them, join them”.

7. Unanimity
Illusions of unanimity exist among group members, when silence is viewed as agreement. As market bubbles grow, there were experts in the private and public sectors who kept silent about how things were unfolding. Hardly an objection was heard, and those who dared counter the majority were scoffed at. Does this mean that those “in the know” who said nothing about the elephant in the room could be construed as unanimous in supporting the shenanigans occurring in the real estate and credit industries?

8. Mindguards
Mindguards are self-appointed members who shield the group from dissenting information. Irving wrote about committees headed by a leader, but also referred to mindguards as people who prevented opposing points of view from reaching the leader. Can you think of real life mindguards who’ve played big roles in orchestrating certain events in our history?

These symptoms serve as good pointers the next time we find ourselves in extraordinary market cycles and situations. When everyone is in a hurry to buy or sell houses, stocks or gold, there could be ample reason to be skeptical.

Thanks again to Manshu for this insightful article. Please consider visiting One Mint and subscribing to One Mint’s RSS feed here.

Copyright © 2009 The Digerati Life. All Rights Reserved.

{ 6 comments… read them below or add one }

Mena @ NoMoreStudentLoans June 11, 2009 at 8:43 pm

This is very true. This is why I have shied away from joining one.

Rob Bennett June 12, 2009 at 9:32 am

It’s not just in investment clubs that Group Think is a problem.

The entire Passive Investing model of understanding how stock investing works is the product of Group Think.

The Passive Investing model tells us that we don’t need to lower our stock allocations when stocks go to insanely dangerous prices. Do you know what the average price drop was on the four occasions when we went to price levels in the neighborhood of those that applied from 1996 through 2008? 68 percent.

There are lots of good and smart people who believe with their hearts, minds and souls that Passive Investing works. They have been taken in by Group Think. There are lots of people who know otherwise. They have been silenced for so long as the Group Think continues.

Robert Shiller recently said in an interview that he has never felt comfortable saying all that he has learned about stock investing from his research because if he told the straight story he would be branded as “unprofessional.” This is a Yale professor with tenure and a best-selling book. Think how most others who have looked at how stocks have always in the past performed from insanely dangerous price levels feel about spilling the beans.

90 percent of our efforts in the stock investing field are efforts to cover up the realities, not to learn them. We very, very, very much want to believe things that are not so. And hearing others confirm that these things are so makes us feel good. It also delays our retirements by many years.


Manshu June 12, 2009 at 1:53 pm

Thanks for to SVB for letting me guest post, select a wonderful picture and for all the kind words.

@Mena: I’ve never been part of any investment club, but that is more because I prefer to do things on my own and like the freedom. A lot of people I know are part of clubs and like the support.

@Rob: I am not a passive investor myself because I really don’t understand how it works. There is merit in the argument that it makes no sense to buy stocks at the peak and there is also merit in the argument that passive funds have by and large outperformed active funds. So, its really a matter of what you are comfortable with.

Mikael @ Retire Rich June 15, 2009 at 1:32 pm

I think that we’re all part of one or more “groupthink” groups. News and media today has entire populations think in one or the other direction and only very few people will actually stop and question what is being stated and especially if it is in more newspapers, online medias and television. It can be far from the truth but because it is a good story and it is promoted heavily then we’re put in a groupthink-like situation.

I don’t see how we can avoid it. If we need to question everything we’ll become paranoid πŸ™‚


Armando August 5, 2009 at 7:04 am

how effective can groupthink be ?

Mary Hall October 21, 2009 at 8:46 pm

While I did plan to start businesses with a few close friends (which in itself might seem like a risky move), I’ve never really been part of an investment club. But I think, as Manshu pointed out, it might be a little too restrictive. Support would be good but I’m not sure how effective it will be production-wise.

Leave a Comment