They’re gonna get FDA approval any day now—I’ve
talked to all the main investigators who studied their drug.”
F told me she had cold-called neurologist and psychiatrist researchersat 12 medical centers where the drug had been tested, and they had beenquick to praise the compound.
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When I expressed some skepticism and concern that researchers don’tsee the long-term side effects data, and they had all been blinded to the realidentity of the compound during those trials, she dismissed my concernswith a self-conﬁdent wave of her hand.
“I’d buy it for your children’s college fund is what I’d do.”Wow! Now to me that seemed like a pretty heavy endorsement—I’d benegligent not to wager my children’s college education on this one. I hadn’tseen F get so excited about many things in the past. She was practicallyobsessed with this company and its product.
I knew that her fund has had great success over the years, with agreater than 20 percent average annual return since 1996. I’d previouslymet with the founder of the fund. “We don’t buy anything unless we’re sureit’ll jump 30 percent over the next year,” he’d said.
Neurocell was a guaranteed winner, a great company endorsed by ahedge fund with a fantastic track record. It looked like a ‘strong buy’ if I’dever heard one. I brieﬂy thought, “I shouldn’t buy this stock based on atip,” but then the certainty of someone who had called 12 medical centersinfected me.
I bought a few shares. And then I bought some more shares until Ihad accumulated, in hindsight, too many. The FDA approval letter was ex-pected any day, and the excitement was building.
But then the FDA rejected Neurocell’s application. Ouch.The FDA’s letter was pessimistic due to a higher rate of strokes in peo-ple who received the drug, but it still had a chance for approval. More datawas needed from the company. The FDA rejection caused a 60 percent de-cline in Neurocell’s stock price within the ﬁrst week.
My doubts were festering. “Why did I buy this stupid stock?” I askedmyself. “I don’t know anything about cardiac catheterization, and now I’velost 60 percent!”
I soon realized I was in deeper trouble than I knew.I heard from F a week after the FDA rejection letter. She sounded veryupbeat. She said, “Gosh, work’s been crazy. Neurocell is at such a discount,we’re buying as much as we can get. We bought a ton the ﬁrst day of thedrop.”
“Buying more?” I thought incredulously. Now I’ve done some quantita-tive research in my time, and the general price pattern after a surprisinglynegative news shock is a brief dead-cat bounce, and then more selling. Whyhad she bought on the ﬁrst day of the decline? Then I remembered the oldsaying from business lore, “If you don’t know who the sucker is, then it’sprobably you.” Oh. Double-ouch.
Of course, F didn’t tell only me to bet the ranch on Neurocell. She had
also endorsed the stock to many of her other friends and family.
Now F was in a bit of a pickle. She had many friends with money lost,and so she was compelled, via the sunk-cost bias (like the endowment
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effect), to continue cheerleading Neurocell. She had all this social pressureto deliver good news, and she was stuck in the frame of positive analysis.She couldn’t be objective anymore.
If you’ve ever given a stock tip, you’ve probably regretted it. In general.by the time someone gets excited enough about a stock to recommend itto others, much of the good news has been priced in. It probably alreadyappreciated in price, and chances are that other owners feel as enthusiasticas you—not usually a good sign. Plus, when you commit yourself to a stockby declaring it a sure winner to your social group, then for the sake ofconsistency, your mind will have trouble abandoning that belief.
I sold my Neurocell shares shortly thereafter. I hadn’t had a plan incase of an FDA rejection letter. I had been too ill disciplined to make one.“When in doubt, get out,” as the old Wall Street saying goes. If you let yourguard down just a little, Mr. Market will always make you the sucker.
Following stock tips is one type of herding. In ﬁnance, herding refersto the collective and contagious inﬂuence of investment ideas. When themajority of investors are following a leader’s advice, without doing the nec-essary due diligence themselves, they are herding.
HERDING
“Men, it has been well said, think in herds; it willbe seen that they go mad in herds, while they onlyrecover their senses slowly, and one by one.”
—Charles MacKay2
Biologically speaking, herding refers to the tendency of some speciesof animals to seek safety in numbers. Herding occurs both when animalsfeel threatened and when they sense that one of their number has found anopportunity. Sometimes the entire ﬂock startles abruptly into ﬂight. Some-times they rush simultaneously into the same green pastures.
Investors often confuse herding with other phenomena. Groupthink isthe tendency for members of homogenous groups to come to the same(and often wrong) conclusion. “Mob” or “crowd” behavior refers to thecontagious quality of sudden actions by someone in a crowd—usually to-ward panic or violence. Groupthink is a particular problem for investmentcommittees, while an example of crowd behavior is a run on a bank, as inMoscow during the Russian debt default and ruble devaluation in 1998.
Is herding really such a bad thing? It can cost you money if your timingis poor, but if you’re a ﬁrst mover, it can make you rich. By the time you seethe herd stampeding, you may be too late to get out of the way. However,
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if you identify a greener pasture, you can get there ﬁrst. When the crowdfollows, you will be well positioned.
Leadership is an essential feature of herding. Sheep follow the alphamale. Often, a sheepdog can direct an entire ﬂock by identifying and cajol-ing the leader alone. This tendency to follow becomes more pronouncedwhen fear (as of a predatory sheepdog) sets in.
In the markets, you can make money by watching the leaders. Whereare they focusing their attention? What are they selling off? In publiclytraded companies, the leaders are the executives, board members, andother insiders. Often when there is signiﬁcant insider selling or a secondaryoffering, trouble follows. Of course, the insiders will never acknowledgethe warning. As a savvy investor, it’s your job to scrutinize, not follow, au-thority.
In 2000, I did some interesting work at a hedge fund in San Francisco.The partners were scouring the United States markets for inexpensive rail-road and energy stocks. If you recommended railroad or coal stocks toyour golf buddies in 2000, they would have thought you were crazy. Ofcourse, in 2000, the herd was in Internet, technology, and biotech stocks,not in energy. But this fund was prescient. In 2002, the market’s vanguardmigrated into railroad and energy stocks. By 2006, such stocks were thedarlings of the market. Many of the stocks of the hedge fund I worked forhad appreciated tenfold.
It is relatively easy to see investors herding if one watches money ﬂowsand media attention. However, it is not easy to identify the next fresh pas-tures, and it is particularly difﬁcult to prevent oneself from following theherd. Social and peer pressure can be intense.
Within a decision-making body, such as an investment committee orboard of directors, herding is very difﬁcult to prevent. Groupthink, defer-ence to authority, and social pressure to agree cause herding among in-siders. The presence of authoritative or charismatic leaders often uninten-tionally stiﬂes dissent. It feels socially unacceptable to contradict a groupleader, even when members are encouraged to do so. Identifying the pro-cess of herding, preventing it in oneself and one’s groups, and taking ad-vantage of it in the markets, is the theme of this chapter.
SOCIAL PROOF
“Let me tell you the story of the oil prospector whomet St. Peter at the Pearly Gates. When told his oc-cupation, St. Peter said, ‘Oh, I’m really sorry. Youseem to meet all the tests to get into heaven. Butwe’ve got a terrible problem. See that pen over there?
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That’s where we keep the oil prospectors waiting toget into heaven. And it’s ﬁlled—we haven’t got roomfor even one more.’ The oil prospector thought for aminute and said, ‘Would you mind if I just saidfour words to those folks?’‘I can’t see any harmin that,’ said St. Pete. So the old-timer cupped hishands and yelled out, ‘Oil discovered in hell!’ Im-mediately, the oil prospectors wrenched the lock offthe door of the pen and out they ﬂew, ﬂapping theirwings as hard as they could for the lower regions.‘You know, that’s a pretty good trick,’ St. Pete said.‘Move in. The place is yours. You’ve got plenty ofroom.’ The old fellow scratched his head and said,‘No. If you don’t mind, I think I’ll go along with therest of ‘em. There may be some truth to that rumorafter all.’
—Warren Buffett retelling a favorite story ofBen Graham
Too often, we learn what to do in an uncertain situation from observ-ing others. We wait for others to “conﬁrm” the right course of action ratherthan assuming the responsibility to ﬁgure it out ourselves. PsychologistRobert Cialdini calls the search for conﬁrmation “social proof.”3 Socialproof provides a mental shortcut. Rather than having to think through eachstep of a problem, people can simply watch their comrades and follow theirlead. Then they ride on their coattails.
In the markets, herd behavior usually ends in losses for the latecomers.Investors succumbing to social proof and herding have depended on oth-ers’ critical decision making. When herd leaders are shown to be wrong,most mistaken investors then begin to lose faith and bail out. However, formany, strong emotional defense mechanisms kick in. They cannot acceptthat their beliefs and their leaders are wrong.
Such true believers were among the investors promoting Internetstocks both on the way up and on the way down in the early 2000s. Theycould not change their ﬁrm beliefs about the promise of Internet stocks.It wasn’t until many of the stock analyst cheerleaders of the Internet bub-ble were indicted for crimes in 2002 that they ﬁnally lost the mass of theirfollowings.
Strangely, even after the “new Internet economy” was shown to bea fantasy, many true believers continued to proselytize vigorously. Whywould anyone continue to identify with a style of thinking that had beenproven wrong, much less try to spread the word? It is too painful for theseproselytizers to accept defeat, so in a move reminiscent of loss aversion,they hold on for any sign of hope, and even try to gather new converts.
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In the minds of die-hard believers, the greater the number of people whobelieve their doctrine, the more likely they themselves are to be correct.
Sometimes investors will feel compelled to follow a price trend. Thisis a type of “herding-by-proxy.” They know others are buying the stock,but they don’t know who. When a stock is trending, people are prone tobelieve that the investors driving the price move know the future betterthan them. They then “chase” the trend higher. Some investors wait forsuch price “conﬁrmation” (favorable trend) before entering an investment.An expected price movement “conﬁrms” that one’s opinions were correct,and it now feels safe to open a position.
If the market is declining sharply, and investors feel nervous, they willlook at the actions of acknowledged leaders, to see how best to respond.Investors especially look to those they see as similar to themselves. If an in-vestor identiﬁes with members of his investing club more than Wall Streetpersonalities, then he will likely take his cues from his colleagues duringtimes of uncertainty, and especially from the acknowledged leaders of theclub.
SOCIAL COMPARISON
“After reading some part of the history of Alexan-der, Caesar sat a great while very thoughtful, andat last burst out into tears. His friends were sur-prised, and asked him the reason of it. “Do youthink,” said he, “I have not just cause to weep, whenI consider that Alexander at my age had conqueredso many nations, and I have all this time donenothing that is memorable?”
—Plutarch in Life of Caesar
At that stage in his life—his mid-30s—Caesar was known as an accom-plished lawyer, second only to Cicero, but also as a man too much in debtfor his own good. All his military feats—and they were spectacular—cameshortly after this expression of grief. In fact, after lamenting his inferiorstatus to Alexander the Great, Caesar moved quickly to pay off his debtsand conquer previously independent tribes of Spain.
Caesar was reacting to an unfavorable social comparison. He derivedhis goals and personal expectations from the life of Alexander the Great,and he calibrated his performance against that of his role model. Af-ter realizing that he had fallen behind Alexander’s example, Caesar im-mediately set about to repair his creditworthiness and reestablish hismilitary reputation.
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Social comparison can explain one’s level of satisfaction with their ﬁ-nancial circumstances. Most people prefer being the “big ﬁsh in a smallpond” when it comes to their wealth. In 1995, Harvard researchers askedsubjects if they would prefer to live in a society where they had an incomeof $50,000 and the average person had an income of $25,000, or wouldthey prefer to have an income of $100,000 in a community where the aver-age person had an income of $200,000 (prices were speciﬁed as constant).Among the 159 students interviewed, 52 percent preferred the $50,000 in-come. Thirty-ﬁve percent of the 75 Harvard faculty and staff answered sim-ilarly. They chose to earn half as much money in absolute terms as long asthey could make twice as much as the average in their community.4
Comparisons to peers not only drive goal pursuit, they also motivateus to overcome deep fears. Albert Bandura, a famous social science re-searcher, has shown that people can be cured of phobias simply by watch-ing someone they identify with, who has a similar phobia, overcome itthemselves. Adults with herpephobia (fear of snakes) can be cured of theirfear by watching videos in which actors, pretending to be fearful of snakes,gradually overcome their phobia on screen. By the conclusion of the video,the actors have the snake draped over their shoulders.
Bandura did a study with nursery-school-age children who were terri-ﬁed of dogs. The fearful children watched other children play with dogsfor 20 minutes each day. After four days, 67 percent of the previously ter-riﬁed children were willing to climb into a playpen with a dog and remainconﬁned there, petting and scratching it, while everyone else left the room.The children recovered from their fear even more quickly when watching avideo with a variety of children playing with dogs. Apparently, social proofworks best when the proof is provided by lots of other people.5
Bandura’s study may apply to the weakening of investors’ risk aver-sion. Investors’ fear of a risky market sector declines as they watch othersbuy into it. On my own, I never would have bought Neurocell stock. Hear-ing about my friend F and our other mutual friends buying shares of Neu-rocell lowered my risk perception. Without doing my own due diligence, Iwas convinced that Neurocell was a guaranteed winner based on watchingother people. My usual cautionary red ﬂags had been lowered by the sirensong of guaranteed proﬁts and shared experience.
ASCH AND CONFORMITY
In 1951, social psychologist Solomon Asch devised an experiment to ex-amine the extent to which pressure from other people could affect one’sperceptions. A participant was placed in a group of 8 to 10 other “partici-pants” (actually conﬁdants of the experimenter). The group was shown a
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Exhibit 1
Exhibit 2
A
B
C
FIGURE 17.1 Experimental columns similar to those used by Solomon Asch.
picture like that in Figure 17.1 and told that the experimenter was studyingvisual perception. Each group member was then asked to state out loudwhich line in Exhibit 2 most closely resembled that in Exhibit 1. The actualexperimental subject answered second to last.
The experimenter’s conﬁdants were instructed to report that lines C orB were most closely related to the line in Exhibit 1 on 12 of the 18 trials—aclearly false answer. Out of 50 subjects in this experiment, 37 conformedto the majority at least once, and the average subject conformed on 4 of the12 trials. After further experiments, Asch concluded that people conformfor two main reasons: because they want to be liked by the group and be-cause they believe the group is better informed than they are.
INFORMATION CASCADES
Investors typically get their investment information from similar sources—data providers, Securities and Exchange Commission (SEC) ﬁlings, a com-pany’s customers and suppliers, corporate executives and employees, andthe media. While investors have different ways of processing the informa-tion, there is a limited number of potential sources.
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At times, the available information leads investors to similar conclu-sions. When these conclusions are acted on, they cause market price move-ments. Some investors take their directional cues only from the marketprice action, which they use as a proxy for the actions of better-informedinvestors. An informational cascade occurs when someone, having ob-served the actions of those preceding, mimics their behavior.
It’s not only price action that can induce an informational cascade bycommunicating what others are thinking and feeling. Many investors in-advertently observe the verbal, body language, and emotional cues fromtheir colleagues and media personalities. This nonverbal communicationreﬂects “the pulse of the market.”
The downside of such nonverbal communication is that people who in-teract with each other frequently tend to think and behave similarly.6 Theyderive similar conclusions from new information, and they respond in kind.Studying the language and nonverbal cues of people within such a groupcan provide insight into their collective reasoning. As seen in Chapter 1, byunderstanding biased collective reasoning an outsider can gain the abilityto identify market opportunities.
Stock message boards are a common gathering place for investors whowish to discuss a stock’s future (and who want to debate each other’s com-petence). Amidst the name-calling and raucous debate on stock messageboards, researchers have found that useful information can be extractedfrom the language that participants use.
In a fascinating and technically demanding study, Professor Sanjiv Dasat Santa Clara University and colleagues analyzed 103,000 stock messageboard postings from 12,000 unique users over a seven-month period. Theresearchers found that there is a positive correlation between the num-ber of postings, stock trading volume, and subsequent stock price under-performance. More messages are written as stock prices decline, and theopinions of investors become more diverse (and presumably less bullish)as prices fall. Loss aversion is evident in posting discussions, with investorshoping for a price rebound. Overall message board sentiment is a reactionto prior trading volume and price action. According to Das, there was nopredictive power to be gained by measuring sentiment.7
STANLEY MILGRAM AND THESHOCKING TRUTH
Many investors do not realize the extent to which they are inﬂuenced bymarket experts and opinion leaders. One classic and disturbing study onthe “authority effect” was carried out in the decades following World War
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II. Stanley Milgram, a professor at Yale University, was planning to investi-gate the obedience of Germans to authority, with the goal of gaining insightinto the rise of authoritarian Nazism.8 He performed his pilot experimentsat Yale, and he quickly realized that he didn’t need to go overseas to ﬁndincredibly compliant subjects.
Milgram’s experiments provide clear evidence that people are wired tofollow authority, even in very sadistic ways. When experimental subjectsarrived at Milgram’s psychology lab, they were met by two people: a re-searcher wearing a lab coat and carrying a clipboard and another person,average in all respects, introduced as another volunteer. The other “volun-teer” was actually an experimenter posing as a research subject.
The subjects were told that the experiment was a test of how punish-ment affects learning and memory. The experimenter posing as a volunteerwas selected as the learner, while the real volunteer was assigned to be theteacher. Of course, the teacher believed that the learner was just anothervolunteer, but actually it was the teacher who was being studied in thisexperiment.
The learner attempted to memorize a list of word pairs. After memo-rization, the learner entered a lab room, where he could be viewed througha glass wall. The learner was strapped into a chair, and his skin waswired with false electrodes that appeared to deliver electric shocks. As theteacher read the ﬁrst word of a word pair, the learner tried to rememberand name the other half of the pair. If the learner recalled incorrectly, thenthe teacher was told to administer an electric shock.
For every wrong answer, the teacher announced the voltage of theshock to be delivered and then ﬂipped a switch to administer it. After eachshock, the voltage was increased by 15 volts for the next one. If the teacherasked about the severity of the electric shocks, the researcher respondedthat while painful, they caused “no permanent tissue damage.” In general,the ﬁrst part of the test proceeded normally. But as the voltage climbed,the learner began to complain.
The learner grunted in pain at 75-, 80-, and 105-volt shocks. At 120 volts,the learner yelled into a microphone connected to the teacher’s controlbooth that the shocks are really starting to hurt. At 150 volts, the learnershouted in to the microphone, “That’s all! Get me out of here! Get me outof here, please! Let me out!” The researcher continued to pose the nextquestion for the teacher to ask the learner. Inevitably, the teacher contin-ued. Between 200 and 300 volts, the learner writhed and shrieked whenthe shocks were administered. The learner kicked the wall, screamed, andpleaded to be released.
Remember, the learner is an actor and no real shock was being deliv-ered, but the teacher didn’t know this. Two-thirds of the volunteer teacherspulled every one of the shock switches and continued to engage the last
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switch at 450 volts until the researcher ended the experiment. None of theteachers stopped until 300 volts, at which point the learner was emitting,in Milgram’s words, “deﬁnitely an agonized scream.” Many of the teachersappeared anguished at this point, asking the researcher to please stop theexperiment. The researcher simply droned on with the next question, andthe teachers complied with the next level of shock. At 300 volts, the learnershouted that he would no longer provide answers to the memory test. Thatpoint was the ﬁrst time that any of the teachers refused to go on.
Milgram and his colleagues were surprised by the results. Before theexperiment they had asked students and colleagues to guess how manyvolunteer teachers would go up to 450 volts. Their answers fell in the 1 to2 percent range. A separate group of 39 psychiatrists predicted that only1 in 1,000 would be willing to continue to the end of the experiment.9 Ac-tually, two-thirds of the volunteers went to the maximum voltage. Appar-ently, people think they are much more independent of this effect than theyactually are.
In a modiﬁcation of the experiment, even when the learner exclaimedthat he had “heart trouble” and the shocks were beginning to affect hisheart, 65 percent of teachers proceeded to the maximum voltage. In yetanother variation, two researchers were present. As the shock intensityincreased, and the learner cried out for release, one researcher told theteacher to go on, and the other said to stop. Typically, the teachers scannedback and forth between researchers, looking and asking for some indica-tion of who was the higher authority. When they couldn’t ﬁgure out whowas superior, the teachers stopped the experiment.
NICE CLOTHES, FAST CARS,AND FANCY TITLES
“Clothes make the man. Naked people have little orno inﬂuence on society.”
—Mark Twain
When meeting someone for the ﬁrst time, it is not uncommon to in-quire about his or her line of work. Business cards list one’s position inan organization. Short biographical sketches on company web sites referto schools attended, degrees earned, jobs held, and articles or books pub-lished. A pedigree can establish one as an authority, while actual compe-tence must be sorted out later.
More easily apparent at a distance than titles and pedigree, one’s cloth-ing also conveys authority. Researchers in Texas discovered that three and
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a half times as many people follow a jaywalker into trafﬁc when he isdressed in a well-tailored suit as when wearing a work shirt and trousers.10Besides clothing, jewelry and cars are also visible signs of wealth.
In a San Francisco study, researchers driving either luxury cars oreconomy cars stopped in front of a green trafﬁc light. Nearly all motoristsbehind the economy car sounded their horns, and two even rammed intoits rear bumper. Fifty percent of the motorists waited patiently behind theluxury car, never beeping their horns, until it drove on.
Most of us don’t believe we act with such deference to authority. Wewouldn’t wait behind a luxury car or blindly follow the recommendationsof experts. The San Francisco researchers asked a class of students to es-timate what they would do if stuck behind the luxury or economy car ata green light. Male students estimated that they would honk faster at theluxury car than at the economy car, believing they would do the oppositeof what actually occurred.11
In the electric shock experiment, Milgram’s colleagues greatly under-estimated the percentage of people who would increase the voltage to themaximum. We don’t think it could be us. Social psychologist Robert Cial-dini describes obedience to authority as occurring beneath awareness, in a“click, whirr” reaction. Subconsciously, after receiving an instruction froman authority, we move from thinking about a situation to reacting. “Infor-mation from a recognized authority can provide us with a valuable shortcutfor deciding how to act in a situation.”12
Financial analysts are Wall Street’s authorities on stocks and marketsectors. Their opinions and recommendations lead to shifts of billions ofdollars across securities. Given the results of Milgram’s experiment, it isno surprise that investors herd into the stocks recommended by analysts.This is a problem when analysts are corrupt or unethical. In the late 1990s,when star Internet analysts Henry Blodgett, Mary Meeker, or Abby JosephCohen said “Buy,” millions followed at their own peril.
THE NEUROSCIENCE OF COOPERATION
Serotonin appears to modulate the acquisition of socially cooperative be-havior. The amino acid precursor of serotonin is tryptophan (Trp). Its rolein the brain is described in Chapter 4. When tryptophan is removed fromthe diet, brain levels of serotonin are depleted. In a prisoner’s dilemmagame (a trust and cooperation game, deﬁned in the glossary), Trp-depletedvolunteers defected more and cooperated less on the ﬁrst day after deple-tion, as if low serotonin levels increased self-interest and decreased coop-erativeness.
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On functional magnetic resonance imaging (fMRI) scanning during theprisoner’s dilemma task, anterior cingulate gyrus and orbitofrontal cortexactivation were decreased in Trp-depleted volunteers, implying that peo-ple with low serotonin require less social reinforcement and use less pre-frontal cortex (impulse inhibiting) input when