Julian Morrison recently sat down as a guest of Simon Russell to discuss investor psychology and how it can influence investment decisions. Simon founded Behavioural Finance Australia, a company that helps businesses apply behavioural finance insights to improve financial outcomes and produces a podcast series focusing on these themes.

Investor psychology and behavioural finance are subjects that are very close to our hearts, as psychology can be a huge influence on investor behaviour. To be successful contrarian investors, we need to go against popular opinion and the consensus, so investor psychology is something we pay a great deal of attention to.

In this edition of the podcast, Julian and Simon discuss the power of social influence, where people look to other people to help with their decision making. While following others can be very useful in some areas of life, to be a successful contrarian investor we want to do the opposite.

You can click play button in the image above to listen to the podcast, or if you prefer you can read the transcript below. Any views expressed by Julian on the Behavioural Finance Australia podcast are general in nature and not intended to be advice.

 

 

Podcast transcript

Simon Russell:

Hi, I’m Simon Russell, founder of Behavioural Finance Australia. I’m here with Julian Morrison, national key account manager at the contrarian investment manager Allan Gray in Sydney. Julian and I share an interest in behavioural finance, the impacts of psychological forces on investors and on markets. Welcome, Julian.

Julian Morrison:

Thanks, Simon.

Simon Russell:

Julian and I have done a few things together in the past. I quoted Julian a couple of times in my first book on behavioural finance. And the reason for that was that Allan Gray provided some practical examples of how to apply some of the principles I was discussing in the book about group decision making and other things. We’ve also jointly presented on a number of seminars and workshops on behavioural finance and investment related issues. But today we’re going to focus a brief discussion on one particular element of behavioural finance, being the power of social influence. So, Julian, would you like to kick us off by telling us what you mean or think of by social influence or herding?

Julian Morrison:

Sure. Thank you, Simon. Yeah, by social influence, we would tend to think about the fact that people tend to look at what other people are doing to help inform them about what to do themselves in a particular situation. So if, for example, you’re choosing a restaurant to go and eat at, it works very well in most areas of life. In the restaurant example, you’d much rather go and choose a restaurant where there’s lots of people who look happy and they’re eating and smiling and having a good time than to go to a restaurant that’s dark and dingy, no one’s in it and there’s a waiter swatting flies. So social influence in that type of situation can be a very effective shortcut to making a decision about the best course of action. It’s just that in investing, and that’s the area obviously we’re talking about today, we find it can be counterintuitive. It can actually be counter to making good decisions.

Simon Russell:

Yeah, I think it’s fantastic you’ve raised the positive aspects to it because social influence, I mean, there’s a reason we have all these biases isn’t there? It tends to help us over time. I think the restaurant example is a good one and in fact, in the book, I look at a range of ways that advisors can use social influence, the power of social influence in a positive way to better influence, to nudge clients with the use of social norms with testimonials and case studies, for example. They’re going to help their clients reach better decisions. But a couple of things, I guess. One is that that works in some situations but not in others, which is what we’re going to touch on. And the second thing is often these things are happening beyond our awareness. So yes, you might consciously look at the restaurant that’s got the guy swatting flies as you say, but in many cases actually you can be influenced beyond your awareness. And that’s, I guess, how some of the dynamics can play at in investment markets, which hopefully we can touch on next.

Julian Morrison:

Sure. It’s not always conscious in people’s minds why they’re making decisions.

Simon Russell:

Yeah, and in fact, I gave an example in the book where I ran a little study where I actually gave people an investment scenario and as part of that scenario, I gave them a little bit of information saying, “Hey, some novice investors at a seminar for beginners think that this is a good investment”, and I split people into two groups and thinking, well, logically it should be irrational or irrelevant for me to rely on what these beginner investors think. But when you compare the two groups, the groups who had seen the positive response from their group of novice investors, well, they were more likely to choose that investment than were the other group, as an example.

Julian Morrison:

It’s amazing how powerful it can be.

Simon Russell:

Indeed. So in an investment context, how do you think about social influence? How does it fit into the process?

Julian Morrison:

Well, in terms of an investment perspective, one of the main things that we see social influence  creating is this idea of competition. So in whatever endeavour you’re involved in, and in this case investing, if you face a massive competition in the thing you’re trying to achieve, you’re more likely to get an average result or a poor result than a good result versus if you face no competition. So if you face very little competition, with most things it tends to be easier to do well. One of the ways I’ve tried to describe this in a simplified way is when presenting to a room full of people on this idea of contrarian investing is to say, “Okay, so if I said that there’s 100 people in this room and somewhere in this room, there’s a hidden suitcase and it’s got $1 million in. Three, two, one, go look for it. Whoever finds it can keep the million dollars.”

Now assuming everyone believed me, then a competition would ensue and people would scramble around and you might say that it’s a fair approximation that each person would have a 1% chance of finding that suitcase, given there’s 100 of them. Now if you suddenly reduce the number to two people, and I told them the same thing, whatever the probability is, it’s suddenly risen a lot. It’s more like 50% chance of finding the suitcase and that, albeit over simplified, explains the notion of competition. If you’re involved in an endeavour to do well or to win something, it’s much better not to face lots of competition.

Simon Russell:

How do they get out of the room afterwards at that point? 50% chance you find the suitcase, there’s a 10% chance you get out of the room alive, I guess.

Julian Morrison:

It depends on the other person or people in the room, I suppose.

Simon Russell:

Yeah. One of the examples that I think fits quite nicely with your suitcase example is one of my kids rollerskating examples, where they went to a roller rink, they probably had 100 people. It’s actually quite similar to your suitcase example in that case as well. And they spun the wheel. So they said, “Everybody go to a corner of the rink”, which they labeled A, B, C and D. They spun the wheel and if it came up with A, all the people with A stayed in the competition, but the Bs, Cs and Ds were all eliminated. And then the As got to then reallocate to the As, Bs and Cs. They spun the wheel again and they get to reallocate. So over time you get whittled down to eventual winner. But the concept there I guess is that, well it’s random whether it’s A, B, C or D, so your best strategy actually is to go to the corner with the fewest people.

Simon Russell:

So at least if yours comes up, for which there is a 25% chance in each case, at least you get a better chance of being an ultimate winner if you’re standing with only one or two people than if you’re standing with 25. So how do you think about these sort of concepts and actually apply them in your investment process?

Julian Morrison:

Well, if you think about it the fact that a lot of people are pursuing a particular investment for example, or behaving in the same way toward a particular investment opportunity, should lead to a number of things happening. And so a few of the things that we will look at is simple things like the price movement. So if you have a very strong rise or fall in price, it means that there’s quite a strong reaction or behaviour of people toward that stock. You might look at that in conjunction with broad sentiment and understand what sentiment is and why it is.

So one of the things we look at is broker recommendations. So if all of the brokers in the market are recommending a strong buy on of stock, typically we’ll be very wary of that. We’ll look for independent viewpoints and ask, “Why could that be wrong?” rather than focusing on what these brokers are telling everyone to buy. And vice versa, if everyone’s roundly negative on something it could actually be an interesting idea as a potential investment. It comes down to the sentiment. So what I mean by that is in the world of investing, if you look at the stock market, it’s not that people focus on the wrong things per se. Everyone knows what’s good in the company. You want a company that’s a strong company that’s profitable, that has a rising measure of earnings, that has good management, that has a product that you can see as sustainable or long lasting, where the industry dynamics are positive for the company.

The troublesome thing is that those are all good things, but everybody who would contemplate buying a share wants those things as well. So if they exist, you’re definitely in that long queue. So going back to our example before about not facing competition, this is the idea that you are in a competition or a long queue with many other people to achieve this. So it’s like going to the auction where there’s 50 other people bidding for the house. If you do buy the house you end up paying a high price.

Simon Russell:

Yeah, the auction is interesting. In the book, I have a chapter on property and I talk about auctions in that context as well. But really the same thing applies to buying a business or a private equity transaction, I mean. In that case it’s the winner’s curse, the idea of the winner’s curse. That where you face uncertainty about valuation and where you face competition that the people who are uncertain and happen to be high, well they’re the people who win the auction and they then suffer the curse, the curse being that you paid too much for it. So I talk about different strategies for avoiding the winner’s curse, but one is to avoid competition if you can. Not always easy, of course, if you’re out buying a property to find one that nobody else wants or to avoid uncertainty.

Avoiding uncertainty as well limits the range of potential bids. At least if you suffer the winner’s case, in that case the curse is less worrisome, I guess. You’re less likely to overpay where there’s less uncertainty.

Julian Morrison:

In the investing context, that willingness to let things go and let someone else take something at a high price, what you think is a high price, can be very difficult when all of the headline information sounds appealing.

Simon Russell:

Yeah, I’ll just touch on a couple of other things I’ve talked about in the book. One is the challenge that advisors face in getting clients to think in these sort of terms. Because if clients are sort of stuck in what I’ve called in the book “first order thinking”, so thinking about the company directly and not thinking at all around what I’ve called “second order thinking”. So thinking about how others think about the company. Well, then we’re sort of stuck in the dynamic of how good is the company and not thinking about some of those other issues. So that’s a real challenge, and I give a couple of examples in the book with little games and examples that advisors can use. The Keynes’ beauty contest is one in there.

But the other interesting thing I find, I guess in my work around with professional investment teams is that whilst definitely there’s a higher level of sophistication, definitely people are consciously talking about some of these sorts of issues, there isn’t necessarily a systematic approach across the investment industry to say, “We’ve got a systematic approach, we do our DCF or we do a multiples-based valuation and we do our industry analysis. We’ve got a systematic structured approach around the investing, but do we have a similar structured investment approach, evidence based approach on thinking about the decision making biases of the market and other participants in the market?” Well, the answer to that in my view is much less so. There’s much less sophistication there and there’s, I think, a real area where some improvements can be made to investment processes in the professional context as well.

Julian Morrison:

Sure. I think on the first point in terms of how advisors might explain it to clients, one of the simplest ways to think about it is that successful investing is not necessarily about buying something that is good. It’s about buying something well, and that means underpaying for it rather than overpaying for it. In the context of the fund management industry and the processes applied by fund managers, that behavioural error is just as important as it is for an individual investor. And whilst some people may perceive fund managers as more sophisticated, ultimately fund managers are human beings as well.

Simon Russell:

Some of them. Some of them are. All right. So, well, I’m sure we could talk about this all day. We’d better wrap it up there so we don’t take too much of our listeners’ time, but if listeners would like to get in touch with you, Julian, or find out more about Allan Gray’s approach, what’s the best way?

Julian Morrison:

People can go straight to our website. That’s www.allangray.com.au. My contact details and those of many of my colleagues are on the website and we’d be happy to receive questions or queries from people.

Simon Russell:

Fantastic. And if they’d like to get in touch with me, well, they can read more about the power of social influence, both the positive and the negatives in my new book, Behavioural Finance: A Guide for Financial Advisors. It’s available online through Amazon, book depository and others. It’s primarily designed for financial advisors but also contains a number of strategies that are relevant for super funds, asset managers and others as well. Or people can get in touch with me via my website, behaviouralfinanceaustralia.com.au.

Thanks for your time, Julian.

Julian Morrison:

Thanks, Simon.