Avoiding GroupThink by Investment Master Class
“Society teaches us from childhood that it pays to be part of the group and not be too different” Wilfred Trotter
“Groups can bring out the worst as well as the best in man” Irving Janus
Over the years I've witnessed plenty of costly decisions made by corporate boards and investors as a result of poor group decisions.
A few ago I was reading an interview with Adam Weiss of Scout Capital who recommended the book "Groupthink" written by Irving Janus, a Yale psychologist, in 1982. I always like to read the books recommended by investors with solid track records of compounding capital.
“Both James [Crichton] and I recently read Groupthink, Irving Janis’ classic study of how small, cohesive groups of very smart people can make really bad decisions, such as getting deeper into Korea, the Bay of Pigs, and Vietnam. The main point is to make sure you have a culture that questions everything and vets out all the alternatives before zeroing in on one of them” Adam Weiss
Irving Janus defined the term 'groupthink' as "a mode of thinking that people engage in when they are deeply involved in a cohesive group, when the members' striving for unanimity override their motivation to realistically appraise alternative courses of action. Groupthink refers to a deterioration of mental efficiency, reality testing, and moral judgement that results from in-group pressures".
“When smart men and women combine their intellects to presumably optimise a solution, the result tends to be surprisingly counterproductive. Rather than being boosted by brilliance, groupthink has a perversely dilatory effect on collective reasoning”. Frank Martin
Mr Janus notes "Groupthink is conducive to errors in decision-making, and such errors increase the likelihood of a poor outcome. Often the result is a fiasco, but not always."
The book recounts the fascinating historical account of the fiascos of Pearl Harbor, the escalation of the Vietnam War, The Bay of Pigs invasion, the invasion of North Korea and the Watergate cover-up. Each of these catastrophic outcomes was a product of a group decision from a small body of government officials and advisers who constituted a cohesive group. Each instance contained the characteristics of gross miscalculation about both the practical and moral consequences of the decisions by a group of intelligent individuals who ignored contrary information and failed to sufficiently consider alternative outcomes.
Understanding 'groupthink' provides a key to better decision making. While the book's case studies relate to political fiascos they have implications for all types of decision making by groups, particularly financial decisions. Whether a group is involved in managing an investment portfolio or choosing an investment manager or a corporate board is considering a major acquisition, capital is at risk.
With respect to managing a portfolio, many of the Investment Masters acknowledge the limitations of group decision making, and instead prefer to manage capital on a sole basis.
"It has been my experience that the more power given to the investment specialist and the smaller the influence of the individuals on investment committees, the better the quality of the work accomplished" Phil Fisher
"If no great book or symphony was ever written by committee, no great portfolio has ever been selected by one, either" Peter Lynch
"Like art, portfolio management can rarely be done in teams (or worst in committees). We can add experience but we lose in personal creativity. Like Warren Buffett once said: “My vision of a group decision is to look into a mirror” Francois Rochon
"If there were such thing as the Laws of Investing, they would have been written by Graham, Buffett and Munger. A small team size (ideally one) would be one of these laws" Mohnish Pabrai
"Investing probably is not played best as a group sport" Leon Levy
Mr Janus identifies eight major symptoms of 'groupthink' which he splits into three types as noted below [I have included references for investment consideration in italics].
Type 1 - Overestimations of the group - its power and morality
1. An illusion of invulnerability, shared by most or all of the members, which creates excessive optimism and encourages extreme risk taking.
A classic case study is the violent collapse of the hedge fund, Long Term Capital Management [LTCM] , in 1998. This fund comprising legendary traders, a former vice chairman of the Federal Reserve and two Nobel prize winning economists, had an aura of invincibility combined with phenomenal risk, which almost led to the downfall of the US financial system.
With respect to LTCM, Howard Marks noted "Brilliance like pride, often goes before the fall. Not only is it insufficient to enable those possessing it to control the future, but awe of it can cause people to follow without asking questions they should and without reserving enough for the rainy day that inevitably comes. This is probably the greatest lesson of Long-Term Capital Management"
A more recent case study is the significant de-rating of Valeant, a US pharmaceutical company with a successful early track record and strong CEO which led the company to undertake ever larger acquisitions and implement aggressive drug pricing strategies, that became its undoing.
2. An unquestioned belief in the group's inherent morality, inclining the members to ignore the ethical or moral consequences of their decisions.
The late 1990's collapse of Enron and Worldcom provide two examples of unethical corporate behaviour with respect to corporate accounting and fraud. The more recent conduct of the credit ratings agencies and investment banks in the sub-prime mortgage market that contributed to the Global Financial Crisis is likely a consequence of groupthink.
Type 2 - Closed Mindedness
3. Collective efforts to rationalise in order to discount warnings or other information that might lead the members to reconsider their assumptions before they recommit themselves to their past policy decisions.
"I would say that the typical organization is structured so that the CEO's opinions, biases and previous beliefs are reinforced in every possible way. Staffs won't give you any contrary recommendations - they'll just come back with whatever the CEO wants. And the Board of Directors won't act as a check, so the CEO pretty much gets what he wants." Warren Buffett
4. Stereotyped views of enemy leaders as too evil to warrant genuine attempts to negotiate, or as too weak or stupid to counter whatever risky attempts are made to defeat their purposes.
“I try to assume that the guy on the other side of a trade knows at least as much as I do. Let’s say I buy Texaco at $52 and it suddenly goes down to $50. Whoever sold Texaco at $52 had a perception dramatically different to mine. It is incumbent on me to find out what his perception was” Michael Steinhardt
“In order to invest, we need to have a sizeable analytical edge over the person on the other side of the trade. The market is an impersonal place. When we buy something, we generally do not know who is selling. It would be foolish to assume that our counterparty is uninformed or unsophisticated. In most circumstances, today’s seller has followed the situation longer and more closely than we have, has previously been a buyer, and has now changed his mind to become a seller. Even worse, the counterparty could be a