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 JanusSALT New York 2021: Wences Casares And Peter Briger On The Macro Case For Bitcoin
At this year's SALT New York conference, Wences Casares, the chairman of XAPO, and Peter Briger, the principal and co-chief executive officer of Fortress Investment Group discussed the macro case for Bitcoin. Q2 2021 hedge fund letters, conferences and more XAPO describes itself as the first digital bank of its kind, which offers the "convenience" Read More
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 company insider or an informed industry player working at a key supplier, customer or competitor.” David Einhorn
“I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.” Charlie Munger
Type 3 - Pressure Towards Conformity
5. Self-censorship of deviations from the apparent group consensus, reflecting each member's inclination to minimize to himself the importance of his doubts and counter-arguments.
"Independent directors have to be hard-working people who will attend meetings diligently, ask tough questions and challenge management. We're in the process of looking for directors for one of our companies. Someone I asked about a prospect said "He'll be a pain in the ass to management". Within reason, that's what I want to hear. Relaxed attitudes negate the concept of independence. Directors who serve in perpetuity should be looked at. After enough years, they can conclude their loyalty is to management" Howard Marks
"The reality is that neither the decades-old rules regulating investment company directors nor the new rules bearing down on Corporate America foster the election of truly independent directors. In both instances, an individual who is receiving 100% of his income from director fees – and who may wish to enhance his income through election to other boards – is deemed independent. That is nonsense." Warren Buffett
6. A shared illusion of unanimity concerning judgments conforming to the majority view (partly resulting from self-censorship of deviations, augmented by the false assumption that silence means consent).
"It's equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisers are present and unanimously support his decision (They wouldn't be in the room if they didn't)" Warren Buffett
7. Direct pressure on any member who expresses strong arguments against any of the group's stereotypes, illusions, or commitments, making clear that this type of dissent is contrary to what is expected of all loyal members.
"Whistle-blower Sherrin Watkins has said that questioning CEO Jeff Skilling about the proprietary of the partnerships would have been 'job suicide". CFO Andrew Fastow is said to have cursed at the Enron representatives who negotiated against the partnerships he ran and tried to get one fired." Howard Marks [2002 memo 'Learning from Enron']
8. The emergence of self-appointed members who protect the group from adverse information that might shatter their shared complacency about the effectiveness and morality of their decisions.
Peter Bevelin succinctly described the issues with group decisions in his book 'Seeking Wisdom - From Darwin to Munger'… "In a group we feel anonymous, which reduces our feelings of responsibility. We can't be blamed. This can lead to over-confident risk behaviour. We may also become impulsive and destructive. Imitation, obedience to authority, and the fear of being different are forces that drive crowds. Groups don't encourage differences of opinion. If a member of a group disagrees, he may seem disloyal. Unanimity is better than independent thought. Individuals in the group reinforce each other into believing that they collectively are right. They focus on favourable consequences and ignore the downside."
Mr Janus offers a number of prescriptions to help avoid groupthink including:
1. The leader of the policy forming group should assign the role of critical evaluator to each member, encouraging the group to give high priority to airing objections and doubt.
“One of the best ways to get confidence in an idea is to find a smart person who has the opposing view and listen to all their arguments. If they have a case that you haven’t considered, then you should get out. But they can also help give you more conviction” Bill Ackman
“I stress tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong. “ Ray Dalio
2. The leaders should be impartial instead of stating preferences and expectations at the outset
3. The organisation should routinely set up several independent groups working on the same policy question under a different leader
4. The policy making group should from time to time divide into two or more subgroups to meet separately and then come together to hammer out their differences
"These 'social' difficulties argue for outside directors regularly meeting without the CEO - a reform that is being instituted and that I enthusiastically endorse" Warren Buffett
5. Each member of the policy making group should discuss periodically the groups deliberations with trusted associates in his her unit and report back their reactions
"I have several times leveraged the partners on specific investments because we have so many entrepreneurs and CEO's in our midst with deep domain knowledge. Many times when I have looked at the list and then presented it to one to three of them with my analytics and said to them "Please don't go buy the stock, but could you tell me if I'm thinking about this the right way; What's your take on it or what insight do you have that I may not know?" Mohnish Pabrai
6. One or more outside experts or qualified colleagues who are not core members of the policy-making group should be invited to each meeting and be encouraged to challenge views of core members
"I have a lot of ideas. Most of them are terrible. But what saved me – well, to the extent I’ve been saved – is that… I want to get people with the best knowledge and insights in each one of those key aspects and get a challenge from them." Charles Koch
7. At every meeting to evaluate alternatives at least one member should be assigned role of devil's advocate
"My thought is, if there's no natural sceptic on an investment maybe it would be wise to appoint one to play devil's advocate anyway" Peter Cundill
"I play devil's advocate and make sure the level of analysis has been complete and thorough and that all the relevant resources have been brought to bear" Lee Ainslee
8. Whenever the policy issue involves relations with a rival nation a sizeable block of time should be spent surveying all warning signals from the rivals and constructing alternative scenarios of the rival's intentions
"We continually challenge ourselves by asking, "What can go wrong?" with investments we own or consider owning. By playing mental war games against our best ideas we may gain or lose confidence in an initial thesis, or perhaps come to accept that a long-loved holding should be let go. We call this stress testing process "killing the company." Bruce Berkowitz
“The financial markets generally are unpredictable. So that one has to have different scenarios... The idea that you can actually predict what's going to happen contradicts my way of looking at the market." George Soros
"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments" Seth Klarman
"Charlie and I both think about worst case scenarios a lot" Warren Buffett
9. After reaching a preliminary consensus about what seems to be best policy alternative, the policy-making group should hold a 'second chance' meeting at which members are expected to express as vividly as they can all their residual doubts and to rethink the entire issue before making a definitive choice.
"We are very careful not to close ourselves off to opportunities to hear a well- developed counterview on any of our investments. Vibrant debate is part of our internal process; however, there is no substitute for the argument of an investor who has risked real capital on a view that is in opposition to ours. Without fail, this shines a light on the potential soft spots of an investment and causes us to work even harder to bottom-out the critical elements of our own thesis" Jim Mooney
Avoiding Groupthink is a necessary pre-requisite for investment success. Many of the Investment Masters employ strategies to combat the negative effects of groupthink. As Barton Biggs asserts in his excellent essay "Groupthink = Groupstink" that "Although there are some groupthink countermeasures, the only real defence against this intellectual cancer is awareness".
Further Reading: Investment Masters Class tutorials - Investment Committees, Testing Ideas, Alternative Scenarios, What you Know, Hubris & Humility, Understanding History, Invert, Confirmation Bias, and Checklists.
Sources: 'Groupthink - Psychological Studies of Policy Decisions and Fiascos' by Irving Janus [Yale University]. 1982 Houghton Mifflin Company
'Hedge Hogging' by Barton Biggs. 2006 John Wiley and Sons" - see Chapter 12
"Dare to be Great" Memo - 2006 Howard Marks - Oaktree Capital
'The Essays of Warren Buffett' by Laurence Cunningham, 2nd Edition 2008 - see 'Boards and Managers' and 'Acquisition Policy'