Experimenting with the Truth

by: Richard A. Anderson

In the 1950s psychologist Solomon Asch conducted a series of experiments to investigate the extent to which social pressure from a majority group could affect a person to conform. Asch’s experiments were simple vision tests. A group of eight male college students were placed in a room, shown a card with a line segment on it, and then shown another card with three line segments labelled A, B, and C. One of the line segments on the second card was the same length as the line segment on the first card, while the other two line segments were clearly of a different length. Participants were asked to write down their answers and then give their answers aloud. Seems like a pretty straight forward experiment, but there was a twist.

The participants in the experiment were broken into two groups: a control group and subject group. The control group, which comprised seven of the eight participants, were “in on” the experiment. They were told beforehand what their responses should be when a line was presented. The control group would always answer unanimously, but on some trials they would give the correct answer and on others they would give the incorrect answer.

The subject group, which comprised only one of the eight participants, was naive to the fact that the other participants in the experiment were pawns in the game. The group was seated so that the real participant always answered last.

The result of the experiment was astounding. The participants chose the correct answer with greater than 99% accuracy based on their written answers. However, when participants verbalized their answers, nearly 75% of participants conformed to the clearly incorrect answer at least once.

Esteemed hedge fund manager, author, and professor Joel Greenblatt conducted a similar, but less formal, experiment with 9th grade students. On the first day of class, Greenblatt brought in a jar of jelly beans and a stack of index cards. He passed around the jar of jelly beans and told each student to write down how many jelly beans were in the jar. None of the students knew their fellow students’ guesses. Once they were done, Greenblatt went around the room and asked each student to say how many jelly beans they believed were in the jar.

The results were once again astounding. The total number of jelly beans in the jar was 1,776. The average of the guesses by the students written on the index cards was 1,771 jelly beans. Pretty close. However, the average of the second guesses when students were asked to state their guesses out loud was 850 jelly beans. Quite a difference.

What do these two experiments involving line segment lengths and number of jelly beans have to do with investing? In essence, these two psychological experiments are analogous to the psychology of investing.

When left to our own, we know capital markets have rewarded long-term, disciplined investors. Capital markets have rewarded those investors who diversify and systematically rebalance their portfolios back to their target asset allocation based on their risk profile. These are the things we know to be true in our minds. This is the equivalent of writing our answers on an index card.

Yet, as investors, we are often strongly influenced by what everyone around us is saying. We read things in the newspaper, we hear things on TV, and we have conversations with family and friends about investing. The things we read and hear make us second-guess what we know to be true. When markets are roaring higher we are tempted to chase the new hottest investment. When markets are falling we are tempted to sell to avoid further pain. This is equivalent to sharing our answers out loud for others to hear.

We know what others are saying isn’t right. Everything we hold true tells us they are wrong. So why do we bow to the pressure? That’s the million-dollar question and why there have been so many professionals dedicated to the study of behavioral finance.

The Asch conformity experiment and Greenblatt’s jelly bean experiment show that even when we know something is wrong, we may go along so we don’t face ridicule. We go against what we know to be right because we don’t want to stand out from the crowd. It’s easier to be wrong when everyone else is wrong. It’s hard to stick by our beliefs when everyone else has a differing opinion.

Essentially, we take action simply to take action. But sometimes the decision to not take action is the best course of action. That can be easier said than done.