james montier 2
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Applied Behavioural Finance:
Insights into irrational minds and market
Applied Behavioural Finance:
Insights into irrational minds and market
James Montier: Global Equity Strategy
Strictly Private & Confidential
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The brain is my second favourite organ
Woody Allen
The market can stay irrational, longer than you can stay solvent
JMK
There is nothing so dangerous as the pursuit of a rational investment policy in an irrational world
JMK
Economists are people who look at reality, and wonder whether it would work in theoryRonald Reagan
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2Global Strategy Unit
Taxonomy of biases
Taxonomy of biases
Cognitive dissonance
Regret theory
Hindsight bias
Confirmation bias
Self Attribution bias
Overconfidence
Overoptimism
Illusion of control
Illusion of knowledge
Self Deception
(Limits to learning)
Loss aversion/Prospect theory
Cue Competition
Availability bias
Anchoring/Salience
Catergorization
Framing
Representativeness
Ambiguity aversion
Self control
(Hyperbolic discounting)
Mood
Emotion/Affect
Heuristic Simplification
(Information processing errors)
Casacades
Herding
Contaigon
Imitation
Social Interaction
Biases
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3Global Strategy Unit
The bias blind spot: Everyone else, not meThe bias blind spot: Everyone else, not me
Fundamenta
l
4
5
6
7
8
Selfserving
Selfinterest
Reactive
devaluation
attribution
error
Haloeffect
Biased
assimilation
Cognitive
dissonance
Average American Self
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4Global Strategy Unit
Dual processing theories of thoughtDual processing theories of thought
System One/ X- system
Intuitive
System Two C- System
Reflective
Process Characteristics
Automatic Controlled
Effortless Effortful
Associative Deductive
Rapid, parallel Slow,serial
Process opaque Self aware
Skilled action Rule application
Content on which processes act
Affective Neutral
Causal propensities Statistics
Concrete, specific Abstract
Prototypes Sets
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5Global Strategy Unit
Neuropsychology of dual processing (Liberman)Neuropsychology of dual processing (Liberman)
X X-system
X Amygdala
X Basal ganglia
X Lateral temporal cortex
X C-system
XAnterior cingulate cortex
X Prefrontal cortex
X Medial temporal lobe
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6Global Strategy Unit
Kleins factors for NDM (X-system)Kleins factors for NDM (X-system)
X System X is more likely when:
X The problem is ill-structured & complex
X Information is incomplete, ambiguous and changing
X Goals are ill defined, shifting and competing
X Stress is high (time constraints and/or high stakes)
X Decisions involve multiple participants
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7Global Strategy Unit
X-system can dominateX-system can dominate
2.5
2.6
2.7
2.8
2.9
3
3.1
1 2
Class B players
Masters
Blitz (6 sec per move) Standard (2.25 mins per move)
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8Global Strategy Unit
AffectAffect
The rational model
X Perceptions -> attitudes
X I like this person because I think she is smart and honest
X I like this company because it is low risk and high return
The affect model
X Attitude -> perceptions
X Because like this person, I think she is smart and honest
X Because I like this company, it is low risk and high return
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9Global Strategy Unit
Biased assimilation: When attitudes drive perceptionsBiased assimilation: When attitudes drive perceptions
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
Participants pro death penalty Participants anti death penalty
Studies supporting death penalty
Studies opposing death penalty
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10Global Strategy Unit
Panda and affectPanda and affect
10
12
14
16
18
20
22
24
1 Panda 4 Panda
Dots
Pictures
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11Global Strategy Unit
The dark side of emotionThe dark side of emotion
0
10
20
30
40
50
60
70
80
90
No invest Invest and lost Invest and won
Target patients Norm al players Patient controls
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12Global Strategy Unit
No sign of learningNo sign of learning
40
45
50
5560
65
70
75
80
85
90
1st 5 2nd 5 3rd 5 4th 5
Target patients Normals Patient controls
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Self deception or perception is realitySelf deception or perception is reality
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14Global Strategy Unit
Self deceptionSelf deception
Over-optimism
X People tend to exaggerate their own abilities
X Illusion of control
X Illusion of knowledge
Over-confidence
X People are surprised more often than they expect. Not well calibrated.
X Confidence intervals around a forecast which should yield 2% error,
actually get a 30-40% error
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15Global Strategy Unit
OverconfidenceOverconfidence
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Weather men
Doctors
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16Global Strategy Unit
Overconfidence and investmentOverconfidence and investment
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0.55 0.65 0.75 0.85 0.95 1
Lay people
Professionals
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17Global Strategy Unit
Overconfidence driven by the illusion of knowledgeOverconfidence driven by the illusion of knowledge
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
Previous
month's results
Other knowledge Intuition Guessing
Laypeople Professionals
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18Global Strategy Unit
Does more information improve your accuracy?Does more information improve your accuracy?
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19Global Strategy Unit
The walk down to beatable earnings:
average scale of forecast error at the earnings level US (%, 1986-2000)
The walk down to beatable earnings:
average scale of forecast error at the earnings level US (%, 1986-2000)
Source: DrKW Macro research and IBES
-5
0
5
10
15
20
-23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0
Months
Forec
astError
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20Global Strategy Unit
Trading is hazardous to your wealthTrading is hazardous to your wealth
0
10
20
30
1 2 3 4 5
Net return Turnover
Low Turnover High turnover
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21Global Strategy Unit
Should traders be women?Should traders be women?
0
20
40
60
80
100
All Women All Men SingleWomen
Single
Men-8
-6
-4
-2
0
All Women All Men Single
Women
Single
Men
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22Global Strategy Unit
Bubble echoes in the laboratoryBubble echoes in the laboratory
Source: Ackert and Church
0
1
2
3
4
5
6
7
8
9
10
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Novices
Once experienced
Fundamental value
Mixture of twice experienced and novice players
(Ratio of 4/7)
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23Global Strategy Unit
Keyness beauty contest and investment professionalsKeyness beauty contest and investment professionals
01
2
3
4
5
6
7
8
9
10
0 510
15
20
25
30
35
40
45
50
55
60
65
70
75
80
85
90
95
100
Over 1000 players
Average number picked 262/3rds: 17
Average level of thinking 1.6 steps
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24Global Strategy Unit
Self deceptionSelf deception
E 4 K 7
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25Global Strategy Unit
Self attribution biasSelf attribution bias
X Good outcomes are a testament to your skill, bad outcomes are sheer bad
luck.
X How often do you say thats just a blip?
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26Global Strategy Unit
Hindsight biasHindsight bias
X It is a common observation that events in the past appear simple,
comprehensible, and predictable in comparison to events in the future.Everyone has had the experience of believing that they knew all along the
outcome of a football game, a political election or a business investment. The
hindsight bias is the tendency for people with outcome knowledge to believe
falsely that they would have predicted the reported outcome of an event. After
learning of the occurrence of an event, people tend to exaggerate the extent towhich they had foreseen the likelihood of its occurrence.
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II. Heuristic Simplification
Or
There is no such thing as context free decision making
Psychological FoundationsPsychological Foundations
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28Global Strategy Unit
Heuristic SimplificationHeuristic Simplification
X Conservatism Bias
X Hard to give up a view once it has formed. Leads to:
XAnchoring and slow adjustment
X Depends upon saliency of the anchor
X i.e. analysts will change their views from their forecasts slowly
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29Global Strategy Unit
Analysts lag realityAnalysts lag reality
-8
-6
-4
-2
0
2
4
6
8
10
12
Jan
-86
Jan
-87
Jan
-88
Jan
-89
Jan
-90
Jan
-91
Jan
-92
Jan
-93
Jan
-94
Jan
-95
Jan
-96
Jan
-97
Jan
-98
Jan
-99
Jan
-00
Jan
-01
Jan
-02
Jan
-03
Earnings
Forecasts
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30Global Strategy Unit
The Fed modelThe Fed model
Source: Thomson Financial Datastream
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 020.60
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.70
0.60
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.70
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31Global Strategy Unit
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Apr-53
Apr-56
Apr-59
Apr-62
Apr-65
Apr-68
Apr-71
Apr-74
Apr-77
Apr-80
Apr-83
Apr-86
Apr-89
Apr-92
Apr-95
Apr-98
Apr-01
Apr-04
Equities vs. bonds in the US: the Fed model since the 1950sEquities vs. bonds in the US: the Fed model since the 1950s
Source: DrKW Macro research
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32Global Strategy Unit
Simple maths leads to anchoringSimple maths leads to anchoring
X 8*7*6*5*4*3*2*1 = median answer 2250
X 1*2*3*4*5*6*7*8 = median answer 512
X Actual answer = 40,320
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33Global Strategy Unit
Estate agents and anchoringEstate agents and anchoring
80,000
90,000
100,000
110,000
120,000
130,000
140,000
150,000
160,000
1 2
Given Appraisal valueListing Price Lowest acceptable offer
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34Global Strategy Unit
Anchoring and valuationAnchoring and valuation
0
10
20
30
40
50
60
Cordless
mouse
Cordless
keyboard
Average
Wine
Rare Wine Design
book
Belgian
Chocolates
0
0.5
1
1.5
2
2.5
3
3.5
4
Low SS No.
High SS No.
Ratio
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35Global Strategy Unit
Cheap? Surely some mistake - USCheap? Surely some mistake - US
Various valuation measures (x)
Current level 1997-200 Long run*
Trailing reported PE 21.1 29.0 14.0
Operating PE 17.5 22.5 14.9
Forward operating PE 15.6 19.7 12.5
PB 3.0 4.0 2.4
PC 13.0 14.9 9.2
Graham and Dodd PE 27.5 37.0 16.4Hussman PE 19.3 23.5 11.0
Trend PE 22.0 29.0 13.9
Source: DrKW Macro research* the term long run refers to the longest run of data we have which varies from starting in the 1870s to starting in the mid 1980s. All long
run measures end at the end of 1996, effectively stripping out the bubble years.
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36Global Strategy Unit
Psychological foundationsPsychological foundations
X Linda is 31, single, outspoken and
very bright. She majored in
philosophy. As a student she wasdeeply concerned with issues
surrounding equality and
discrimination.
X Is it more likely that Linda is
X Works in a bank
X Works in a bank and is active in
the feminist movement
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37Global Strategy Unit
Psychological FoundationsPsychological Foundations
Representativeness Heuristic
XAka law of small numbers belief that random samples of a population
will resemble each other and the population more closely than statistical
sampling theory would predict.
X Which is more likely HTHTTH or HHHTTT?
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38Global Strategy Unit
Earnings growth as representativenessEarnings growth as representativeness
Source: Montier, & Chan et al
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
Q1 Q2 Q3 Q4 Q5
Trailing 5 year Forward 5 year
Actual 1 Actual 3
Actual 5
Source: Montier, and Chan et al
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39Global Strategy Unit
Great stories Great investmentsGreat stories Great investments
0
2
4
6
8
10
12
14
16
18
Glamour (1) Glamour (2) Value (9) Value (10)
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40Global Strategy Unit
Under-reaction and Over-reactionUnder-reaction and Over-reaction
X Information is judged in two dimensions strength and weight
X Letter of reference judged by strength i.e. number of appealing traits
X Weight is neglected. i.e. who wrote it
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41Global Strategy Unit
Over-reaction and Under-reaction : Information analysisOver-reaction and Under-reaction : Information analysis
Over-
reaction
High
Under-
reaction
Low
HighLow
Weight
Strength
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42Global Strategy Unit
Analysis of over-reaction and under-reactionAnalysis of over-reaction and under-reaction
X Dividend omissions, initiations
X Earnings surprises
X Analyst recommendations
X Z-scores
X Buybacks on value stocks
X Goodwill write-offs
X Valuations
X IPOs, SEOs
X High earnings growth
X Cap ex.
X Buybacks on growth stocks
X Quarterly earnings announcements
Under-reaction Over-reaction
f
f
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43Global Strategy Unit
Bias of JudgementBias of Judgement
X Availability Bias
X Which is a more likely cause of death in the US being killed by a
lightening strike or as a result of a shark attack?
X Shark attacks receive more publicity, they are easier to imagine (thanks to
Jaws). However, the chance of dying from a lightening strike are 30x
greater than chances of being killed by a shark.
N F i
N F i
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44Global Strategy Unit
Narrow FramingNarrow Framing
X Context sensitivity. Aka frame
dependence or mental accounting.
X We cant see through how things are
actually framed.
X Separate funds for separate
purposes holiday money, house
keeping
?
?
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45Global Strategy Unit
When is a buyback not a buy back?
announced, actual and net share buy-backs in the US
When is a buyback not a buy back?
announced, actual and net share buy-backs in the US
Source: DrKW Macro research
-50,000
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Announced
Completed
Net
R h & th i i t
R h & th i i t
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46Global Strategy Unit
Repurchases & their impact:
dividend, repurchase & total yield for the S&P500 (%)
Repurchases & their impact:
dividend, repurchase & total yield for the S&P500 (%)
Source: DrKW Macro research
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
6.00
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Total yield
Dividend yield
Net repurchase y ield
Prospect Theory
Prospect Theory
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47Global Strategy Unit
Prospect TheoryProspect Theory
X People value changes not states.
Rational man tries to maximise the
utility of wealth.
X Real people worry far more about
gains and losses than levels.
-12
-10
-8
-6
-4
-2
0
2
4
-20 -15 -10 -5 0 5 10 15 20
Stock broker Sample
Stock broker Sample
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48Global Strategy Unit
Stock broker SampleStock broker Sample
0
5
10
15
20
25
50100
101
110
150
201
320
500
1000
100
000
Prospect theory
Prospect theory
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49Global Strategy Unit
Prospect theoryProspect theory
Leads to
Endowment effect
Status quo bias
Disposition effect
Endowment effect/Status quo bias
Endowment effect/Status quo bias
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50Global Strategy Unit
Endowment effect/Status quo biasEndowment effect/Status quo bias
0
1
2
3
4
56
7
8
1 2 3
Sellers Choosers Buyers
US mutual fund managers and the disposition effect (1980-2002)
US mutual fund managers and the disposition effect (1980-2002)
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51Global Strategy Unit
US mutual fund managers and the disposition effect (1980 2002)US mutual fund managers and the disposition effect (1980 2002)
Source: Frazzini (2004)
0
5
10
15
20
25
Low return 2 3 4 High
return
All
Proportion of losses realized
Proportion of gains realized
Top tips for better decision making
Top tips for better decision making
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52Global Strategy Unit
Top tips for better decision makingTop tips for better decision making
X This applies to me, you and everyone else
X You know less than you think you do
X Be less certain in your views, aim for timid forecast and bold choices
X Dont get hung up on one technique tool, approach or view flexibility and
pragmatism are the order of the day
X Listen to those who dont agree with you
Top tips for better decisions
Top tips for better decisions
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53Global Strategy Unit
Top tips for better decisionsTop tips for better decisions
X You didnt know it all along, you just think you did
X Forget relative valuation, forget market prices, work out what the stock is worth
(Use reverse DCFs)
X Dont take information at face value, think carefully about how it was presented
to you
X Dont confuse good firms with good investments, or good earnings growth with
good returns
Top tips for better decisions
Top tips for better decisions
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54Global Strategy Unit
Top tips for better decisionsTop tips for better decisions
X Vivid, easy to recall events are less likely than you think they are, subtle
causes are underestimated
X Try to focus on facts, not stories
X Sell your losers and ride your winners
Beating the biases
Beating the biases
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55Global Strategy Unit
gg
X Being aware of the biases is not enough. It is just an important first step.
X Need to create a framework that incorporates mental best practice. Easier said
than done. Mental bad habits are persistent.
X The good news, we continue to create new brain cells throughout our lives.
St i tl P i t & C fid ti l
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Applied Behavioural Finance:
Are two heads better than one?
The psychology of group decisions
Applied Behavioural Finance:
Are two heads better than one?
The psychology of group decisions
James Montier: Global Equity Strategy
Strictly Private & Confidential
Madness is a rare thing in individuals but in groups...it is the rule
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Friedrich Nietzsche
To associate with other like-minded people in small, purposeful groups is for the great majority of
men and women a source of profound psychological satisfaction..
Aldous Huxley
Deliver us from committees
Robert Frost
Committees are groups of people who keep minutes but waste hours
Berle Milton
A committee is an animal with four back legs
John le Carre
A committee is a group of the unwilling, chosen from the unfit, to do the unnecessary
Unknown
Types of groups
Types of groups
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58Global Strategy Unit
Statistical groups = large number of people asked for an answer, take the mean.
Deliberative groups = discussion is necessary
Evidence suggests that statistical groups outperform deliberative groups and
individuals
E.g. when judging the number of beans in a jar, the group average is almost alwaysbetter than the vast majority of the individual members. In one such experiment, a
group of 56 students was asked about a jar containing 850 beans; the group estimate
was 871, a better guess than all but one of the students
Statistical groups
Statistical groups
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59Global Strategy Unit
Only work when:
People are unaffected by others decisions (errors are uncorrelated)
Probability of being correct must be independent of the probability of
everyone else being correct
The participants must be unaffected by their own vote possibly beingdecisive
When participants have some idea of the answer.
Anchors are avoided
Deliberative groups
Deliberative groups
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60Global Strategy Unit
Such groups seem to amplify:
Representativeness
Framing
Overconfidence (simple repetition of views leads to people having greater
confidence)
Anchoring
Availability
The establishment of norms (Sherif 1936)
The establishment of norms (Sherif 1936)
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61Global Strategy Unit
0
1
2
3
4
5
6
7
8
Alone Session 1 Session 2 Session 3
1
23
Conformity (Asch 1955)
Conformity (Asch 1955)
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62Global Strategy Unit
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63Global Strategy Unit
On 12 of the 18 rounds, confederates unanimously agreed on a wrong answer
of participants agreed with the confederates in at least one round. Halfagreed in 6 or more rounds. Only 25% resisted in all rounds!
Does group size matter? (% conforming to wrong answers)
Does group size matter? (% conforming to wrong answers)
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64Global Strategy Unit
0
5
10
15
20
25
30
35
1 2 3 4 15
Herding when uncertain Baron et al
Herding when uncertain Baron et al
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65Global Strategy Unit
0
0.5
1
1.5
2
2.5
3
3.5
4
Unimportant Important
Low uncertainity
High uncertainty
Sharing information (Stasser et al 1989)
Sharing information (Stasser et al 1989)
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66Global Strategy Unit
0
10
20
30
40
50
60
70
80
Unstructured Structured
Shared
Unshared
Why are we so bad at sharing information?
Why are we so bad at sharing information?
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67Global Strategy Unit
Shared information is more likely to be discussed and repeated and this will
influence the individuals in the group, and hence influence the groups eventual
outcome.
Social pressure
Cascades
Social pressure : Those who conform are rewarded (Wittenbaum et al 1999)
Social pressure : Those who conform are rewarded (Wittenbaum et al 1999)
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68Global Strategy Unit
5
5.2
5.4
5.6
5.8
6
6.2
6.4
6.6
6.8
7
Shared Unshared
Self
Others
Cascades
Cascades
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69Global Strategy Unit
Private
signal
a a b b b b
Source: Anderson and Holt (2004)
Cascade creation: Actual pot used B
Player 1 2 3 4 5 6
Decision A A A A A A
Group polarisation
Group polarisation
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70Global Strategy Unit
Group polarization is the tendency for members of a group to end up in a more
extreme position in line with their original beliefs after talking to one another.
The increased confidence in view mentioned earlier, begins to create feedbackinto the extremity of view, generally creating a loop of increased confidence in
more and more extreme views
Groupthink
Groupthink
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71Global Strategy Unit
A tendency to examine too few alternatives
A lack of critical assessment on each others ideas
A lack of contingency plans
Poor decisions are often rationalized
Illusion of group invulnerability and shared morality
True feelings and beliefs are suppressed
Illusion of unanimity is maintained
Mind guards are appointed to protect the group from negative information
Solutions
Solutions
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7/29/2019 James Montier 2
73/76
72Global Strategy Unit
Secret ballots
Devils advocates
Authentic dissent
Respect for other group members
Beware of authority Milgram experiments
Beware of authority Milgram experiments
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7/29/2019 James Montier 2
74/76
73Global Strategy Unit
Banduras driving forces turning good people bad
Banduras driving forces turning good people bad
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7/29/2019 James Montier 2
75/76
74Global Strategy Unit
Moral justification
Euphemistic labelling
Advantageous comparison
Displacement of responsibility
Diffusion of responsibility
Disregard or distortion of consequences
Dehumanisation
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7/29/2019 James Montier 2
76/76
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