Improving Investor Behavior: Safety in numbers

In 1962, an experiment on the television show Candid Camera showed several participants in an elevator, facing backward toward its rear (“Face the Rear” episode). When the door opened on another floor, a new passenger then faced a choice: Turn to face the doors like normal or face the back of the elevator along with everyone else.

At first, the confused subjects looked around to decipher any reason for everyone else’s strange behavior. Then, after a few moments, most people slowly chose to face the back. The social pressure was so strong that even though it made no logical sense, people instinctively followed the crowd.

This experiment was one of many designed by Solomon Asch, a pioneer in social psychology. Best known for his “conformity experiments,” Asch studied how peer pressure changes opinion and perception. His first experiment, conducted in 1951, has interesting implications for investor behavior.

In the experiment, eight participants were given a pair of cards illustrating lines: a single line on one card, three on the other. Participants were then asked aloud which of the three lines was identical in length to the single line on the other card. (One line was always a perfect match.) Unbeknownst to a single participant, the other seven people were aware of the experiment and instructed to respond in certain, predetermined ways.

This process repeated several times to see if the unknowing responder (always the last to reply) would change their answer based on others’ replies. By round three or four, the group intentionally started to answer incorrectly to see if the subject would go along with them.

The results were surprising. About 65% of the time, participants stuck with the correct answer, despite how others were responding. Roughly 12% of participants went along with what the group was doing every time. The rest varied in responses. In total, roughly 74% gave at least one incorrect answer. When asked why, they linked their reactions to self-doubt, a desire to fit in, and even perceived confusion over the question.

A variation of the experiment involved a “true partner” (someone instructed to always give the correct answer) assigned to the participant. Interestingly, when people were assigned a partner, the error rate dropped to about 5%. Subjects said that a partner “increased their confidence” but humorously insisted they were still acting independently. Ah, the power of influence.

These examples indicate a simple conclusion: People tend to follow the herd. Instinctually, it makes sense: There’s safety in conformity. But is that true in finance?

As of Dec. 31, the “Magnificent Seven” — the seven largest companies in the S&P 500, accounted for roughly half of the Index’s 2024 gain, according to CNBC. They also represented about 33% of the total weighting, dwarfing the other 493 companies in sheer size. This has left many people wondering, are these companies deserving of this much capital, or is a bubble inflating America’s largest enterprises?

The simple answer is no one knows. Historically we’ve had our share of bubbles, which only appear obvious in hindsight. The fear of missing out drives irrational optimism, which in turn drives greed, which then causes people to abandon all sense of reality in pursuit of ever-higher prices. That’s FOMO at work.

But at the same time, while researching this article, I came across several news stories — dating back to 2021 — asking if the Magnificent Seven were a bubble. Investors who heeded these warnings and avoided these stocks over the last four years missed out on quite a bit of return. For better or worse, crowds have an uncanny ability to drive up prices.

Unlike the experiment, we don’t possess a piece of paper to guide us in an obvious choice. Instead, we have only historical metrics and opinions. On the numbers side, the valuation metric price-to-earnings ratio of the Mag Seven reveals an average of about 32, or roughly 33% above the market’s average of 24. While that number may be high, I’d argue it’s not outrageous. The reality is that these companies generate a stunning amount of revenue and are uniquely positioned. Is that worth a relatively rich valuation?

To answer that question, too often we turn to the opinions of others. Instinctually, people believe in the safety of conformity, so they watch which way everyone else in the elevator is facing. That’s why it’s important to understand your why and why now for owning a particular asset. One of these will help determine your why and what to invest in; the other will help you understand if it’s the right time.

If you struggle with either of those questions, an adviser might be helpful. Akin to the experiment, having a “true partner” can help you better navigate the current landscape and your goals. So often, clients become friends and friends become clients for this exact reason.

Friends help friends avoid the herd mentality. They keep them grounded in solid fundamentals, reminding them of the limits to persistent dominance in a business or industry. Rarely do companies stay on top indefinitely. When investing, guard your emotions, stay objective and try to avoid unreasonable speculation.

(The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.)

Steve Booren is the founder of Prosperion Financial Advisors in Greenwood Village. He is the author of “Blind Spots: The Mental Mistakes Investors Make” and “Intelligent Investing: Your Guide to a Growing Retirement Income” He was named by Forbes as a 2024 Best-in-State Wealth Advisor, and a Barron’s 2024 Top Advisor by State.