In 1951 Solomon Asch, of Swarthmore College in the US, conducted one of the most famous conformity tests.
The set-up was simple.
The experiment involved eight people sitting in a room. Seven of the participants were ‘insiders’. They knew the real purpose of the experiment. They had instructions to obey the commands of Asch and his team.
The eighth participant was the ‘guinea pig’. He or she was an outsider. They had no idea about the real purpose of the experiment.
The dangerous power of conformity
The experiment involved showing the participants the two following cards:
They had to answer which of the lines on the right hand card matched the line on the left hand card. Simple, right?
It should be. But here was the trick. The researchers instructed the seven ‘insiders’ to answer incorrectly, but they would all have to answer the same way – for instance they would all say that A was the matching line.
Now, A is clearly the wrong answer. But the set-up meant that the ‘guinea pig’ was always the last to answer. The objective of the test was to see whether they would give the correct answer (C), or whether they would follow the crowd and give the incorrect answer (A).
The results were stunning.
For all experimental groups, three-quarters of the participants gave at least one wrong answer, even though the correct answer was obvious.
Even more amazingly, in interviews conducted after the tests, most of the ‘guinea pig’ participants reported a distortion of judgement. That means even though the correct answer was obvious, the participants began to believe they must be wrong because the rest of the group gave an alternate answer.
It just goes to show how keen most people are to conform, and the pressure people feel. Even though something was obvious, they went against their better judgement because they didn’t think it was possible everyone else could be wrong.
In a lab test, there’s no harm done. But as an investor, if you take the same approach it could be disastrous.
The importance of not following the investment crowd
We covered this to some degree in yesterday’s Money Morning. This is the type of investor who is only too eager to follow the crowd.
They know that things don’t quite add up, but heck, everyone else is buying, so why shouldn’t they join in the fun…and the profits?
But following the crowd can be a dangerous way to invest if you don’t understand the risks involved.
That’s why long ago we introduced ‘buy up to’ prices in our paid investment advisories.
It’s a simple concept. When we publish investment research to buy a stock, we always include a maximum ‘buy up to’ price. For instance, if a stock is trading at $1 and our analysis suggests the price could go to $3, we may set a maximum buy up to price of $1.20.
The reason for this is simple (and yet few investors realise it). The more you pay for a stock, the lower your potential profits.
If you pay $1 for a stock that goes to $3 then you’ve made a 200% profit. If you pay $1.20 and it goes to $3 then you’ve made a 150% profit.
But if you chase the stock and pay $1.60 and it goes to $3 then you’ve ‘only’ made an 87.5% profit.
That may still seem pretty good. But remember, stocks don’t always behave how you expect. Sometimes they go down. So if you rush in to buy at $1.60 there’s no guarantee the price will keep going up.
But if you’re the type of investor who follows the crowd just because you believe the crowd is always right, then you’ll consistently find that you’re paying more than you should for stocks.
It also means you’ll find that you rarely lock away any profits.
Resist the pressure of the investment crowd
But that’s what most investors do.
It’s why most investors tend to buy stock when prices are already going up. It’s the urge to conform…to follow the crowd.
You won’t find many investors who will buy a stock when it’s bumping along the bottom of the market. Doing that involves taking initiative and going against the grain.
You may have experienced the pressure to conform when you’re chatting to friends or family about stocks. If you bring up the idea of buying shares, they’ll probably say you’re mad.
If it’s just one person telling you that it’s easy to fight your corner. But if there are three, four or five people telling you that buying stocks is a bad idea, you’re more likely to go along with it. After all, they couldn’t all be wrong, could they? Refer back to the Asch test.
But that’s all part of being a contrarian investor. Being a contrarian investor means having the smarts to identify new trends before everyone else.
So rather than seeing your minority position as a negative, see it as a positive. If everyone is telling you that it’s a bad time to invest in stocks, there’s a good chance you may be on to something.
Right now, we’re hearing that message non-stop from almost everyone we speak to. We see that as a good sign. Remember, just because there are more people saying it, doesn’t mean they’re right.
Cheers,
Kris+
PS: You can quiz me on my bullish stock market views in person at the upcoming World War D conference in Melbourne at the end of next month. I’ll be on the stage with global finance gurus Dr Marc Faber, Jim Rickards, and Satyajit Das. You can find out more here about what I consider to be the best money and finance conference in Australia this year. Click here for the revealing trailer…
From the Port Phillip Publishing Library
Special Report: Retirement Security Ladder
