Applied Behavioural Finance: Insights into irrational ... · Applied Behavioural Finance: Insights...

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Applied Behavioural Finance: Insights into irrational minds and market James Montier: Global Equity Strategy Strictly Private & Confidential

Transcript of Applied Behavioural Finance: Insights into irrational ... · Applied Behavioural Finance: Insights...

Page 1: Applied Behavioural Finance: Insights into irrational ... · Applied Behavioural Finance: Insights into irrational minds and market Applied Behavioural Finance: Insights into irrational

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Applied Behavioural Finance: Insights into irrational minds and marketApplied 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 theory”

Ronald Reagan

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2Global Strategy Unit

Taxonomy of biasesTaxonomy of biases

Cognitive dissonance

Regret theory

Hindsight bias

Confirmation bias

Self Attribution bias

Overconfidence

OveroptimismIllusion 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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The bias blind spot: Everyone else, not meThe bias blind spot: Everyone else, not me

Fundamental

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Self serving

Self interest

Reactive

devaluation

attributionerror

Halo effect

Biased

assimilation

Cognitive

dissonance

Average American Self

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Dual processing theories of thoughtDual processing theories of thought

System One/ X- systemIntuitive

System Two C- SystemReflective

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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Neuropsychology of dual processing (Liberman)Neuropsychology of dual processing (Liberman)

X-system

Amygdala

Basal ganglia

Lateral temporal cortex

C-system

Anterior cingulate cortex

Prefrontal cortex

Medial temporal lobe

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Klein’s factors for NDM (X-system)Klein’s factors for NDM (X-system)

System X is more likely when:

The problem is ill-structured & complex

Information is incomplete, ambiguous and changing

Goals are ill defined, shifting and competing

Stress is high (time constraints and/or high stakes)

Decisions involve multiple participants

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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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AffectAffect

The rational model

Perceptions -> attitudes

I like this person because I think she is smart and honest

I like this company because it is low risk and high return

The affect model

Attitude -> perceptions

Because like this person, I think she is smart and honest

Because I like this company, it is low risk and high return

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Biased assimilation: When attitudes drive perceptionsBiased assimilation: When attitudes drive perceptions

-2.5

-2

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Participants pro death penalty Participants anti death penalty

Studies supporting death penaltyStudies opposing death penalty

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Panda and affectPanda and affect

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1 Panda 4 Panda

Dots

Pictures

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The dark side of emotionThe dark side of emotion

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No invest Invest and lost Invest and won

Target patients Normal players Patient controls

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No sign of learningNo sign of learning

4045505560657075808590

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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Self deceptionSelf deception

Over-optimism

People tend to exaggerate their own abilities

Illusion of control

Illusion of knowledge

Over-confidence

People are surprised more often than they expect. Not well calibrated.

Confidence intervals around a forecast which should yield 2% error, actually get a 30-40% error

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OverconfidenceOverconfidence

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0 10 20 30 40 50 60 70 80 90 100

Weather men

Doctors

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Overconfidence and investmentOverconfidence and investment

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0.55 0.65 0.75 0.85 0.95 1

Lay people

Professionals

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Overconfidence driven by the illusion of knowledgeOverconfidence driven by the illusion of knowledge

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1.0

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3.0

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Previousmonth's results

Other knowledge Intuition Guessing

Laypeople Professionals

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Does more information improve your accuracy?Does more information improve your accuracy?

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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

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0

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-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

Fore

cast

Err

or

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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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Should traders be women? Should traders be women?

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All Women All Men SingleWomen

SingleMen

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All Women All Men SingleWomen

SingleMen

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Bubble echoes in the laboratoryBubble echoes in the laboratory

Source: Ackert and Church

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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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Keynes’s beauty contest and investment professionalsKeynes’s beauty contest and investment professionals

0123456789

10

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100

Over 1000 playersAverage number picked 26

2/3rds: 17Average level of thinking 1.6 steps

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Self deceptionSelf deception

E 4 K 7

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Self attribution biasSelf attribution bias

Good outcomes are a testament to your skill, bad outcomes are sheer bad luck.

How often do you say that’s just a blip?

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Hindsight biasHindsight bias

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 to which 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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Heuristic SimplificationHeuristic Simplification

Conservatism Bias

Hard to give up a view once it has formed. Leads to:

Anchoring and slow adjustment

Depends upon saliency of the anchor

i.e. analysts will change their views from their forecasts slowly

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Analysts lag realityAnalysts lag reality

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Earnings

Forecasts

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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

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0.80

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0.0

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1.0

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3.0

Apr

-53

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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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Simple maths leads to anchoringSimple maths leads to anchoring

8*7*6*5*4*3*2*1 = median answer 2250

1*2*3*4*5*6*7*8 = median answer 512

Actual answer = 40,320

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Estate agents and anchoringEstate agents and anchoring

80,000

90,000

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150,000

160,000

1 2

Given Appraisal valueListing Price Lowest acceptable offer

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Anchoring and valuationAnchoring and valuation

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Cordlessmouse

Cordlesskeyboard

AverageWine

Rare Wine Designbook

BelgianChocolates

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Low SS No.High SS No.

Ratio

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Cheap? Surely some mistake - USCheap? Surely some mistake - US

Various valuation measures (x) Current level 1997-2004 Long run*

Trailing reported PE 21.1 29.0 14.0Operating PE 17.5 22.5 14.9Forward operating PE 15.6 19.7 12.5PB 3.0 4.0 2.4PC 13.0 14.9 9.2Graham and Dodd PE 27.5 37.0 16.4Hussman PE 19.3 23.5 11.0Trend PE 22.0 29.0 13.9Source: 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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Psychological foundationsPsychological foundations

Linda is 31, single, outspoken and very bright. She majored in philosophy. As a student she was deeply concerned with issues surrounding equality and discrimination.

Is it more likely that Linda is

Works in a bank

Works in a bank and is active in the feminist movement

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Psychological FoundationsPsychological Foundations

Representativeness Heuristic

Aka 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.

Which is more likely HTHTTH or HHHTTT?

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Earnings growth as representativenessEarnings growth as representativeness

Source: Montier, & Chan et al

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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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Great stories ≠ Great investmentsGreat stories ≠ Great investments

02468

1012141618

Glamour (1) Glamour (2) Value (9) Value (10)

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Under-reaction and Over-reactionUnder-reaction and Over-reaction

Information is judged in two dimensions – strength and weight

Letter of reference – judged by strength i.e. number of appealing traits

Weight is neglected. i.e. who wrote it

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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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Analysis of over-reaction and under-reactionAnalysis of over-reaction and under-reaction

Dividend omissions, initiations

Earnings surprises

Analyst recommendations

Z-scores

Buybacks on value stocks

Goodwill write-offs

Valuations

IPOs, SEOs

High earnings growth

Cap ex.

Buybacks on growth stocks

Quarterly earnings announcements

Under-reaction Over-reaction

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Bias of JudgementBias of Judgement

Availability Bias

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?

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.

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Narrow FramingNarrow Framing

Context sensitivity. Aka frame dependence or mental accounting.

We can’t see through how things are actually framed.

Separate funds for separate purposes – holiday money, house keeping

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When is a buyback not a buy back?announced, actual and net share buy-backs in the USWhen is a buyback not a buy back?announced, actual and net share buy-backs in the US

Source: DrKW Macro research

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350,00019

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Announced

Completed

Net

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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

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Prospect TheoryProspect Theory

People value changes not states. Rational man tries to maximise the utility of wealth.

Real people worry far more about gains and losses than levels.

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Stock broker SampleStock broker Sample

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Prospect theoryProspect theory

• Leads to

• Endowment effect

• Status quo bias

• Disposition effect

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Endowment effect/Status quo biasEndowment effect/Status quo bias

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Sellers Choosers Buyers

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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

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Top tips for better decision makingTop tips for better decision making

This applies to me, you and everyone else

You know less than you think you do

Be less certain in your views, aim for timid forecast and bold choices

Don’t get hung up on one technique tool, approach or view – flexibility and pragmatism are the order of the day

Listen to those who don’t agree with you

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Top tips for better decisionsTop tips for better decisions

You didn’t know it all along, you just think you did

Forget relative valuation, forget market prices, work out what the stock is worth (Use reverse DCFs)

Don’t take information at face value, think carefully about how it was presented to you

Don’t confuse good firms with good investments, or good earnings growth with good returns

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Top tips for better decisionsTop tips for better decisions

Vivid, easy to recall events are less likely than you think they are, subtle causes are underestimated

Try to focus on facts, not stories

Sell your losers and ride your winners

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Beating the biasesBeating the biases

Being aware of the biases is not enough. It is just an important first step.

Need to create a framework that incorporates mental best practice. Easier said than done. Mental bad habits are persistent.

The good news, we continue to create new brain cells throughout our lives.

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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

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“Madness is a rare thing in individuals – but in groups...it is the rule”

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

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Types of groups Types of groups

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 always better 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

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Statistical groupsStatistical groups

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 being decisive

When participants have some idea of the answer.

Anchors are avoided

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60Global Strategy Unit

Deliberative groupsDeliberative groups

Such groups seem to amplify:

Representativeness

Framing

Overconfidence (simple repetition of views leads to people having greater confidence)

Anchoring

Availability

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62

61Global Strategy Unit

The establishment of norms (Sherif 1936)The establishment of norms (Sherif 1936)

0

1

2

3

4

5

6

7

8

Alone Session 1 Session 2 Session 3

123

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63

62Global Strategy Unit

Conformity (Asch 1955)Conformity (Asch 1955)

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63Global Strategy Unit

On 12 of the 18 rounds, confederates unanimously agreed on a wrong answer

¾ of participants agreed with the confederates in at least one round. Half agreed in 6 or more rounds. Only 25% resisted in all rounds!

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65

64Global Strategy Unit

Does group size matter? (% conforming to wrong answers)Does group size matter? (% conforming to wrong answers)

0

5

10

15

20

25

30

35

1 2 3 4 15

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66

65Global Strategy Unit

Herding when uncertain – Baron et alHerding when uncertain – Baron et al

0

0.5

1

1.5

2

2.5

3

3.5

4

Unimportant Important

Low uncertainityHigh uncertainty

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67

66Global Strategy Unit

Sharing information (Stasser et al 1989)Sharing information (Stasser et al 1989)

0

10

20

30

40

50

60

70

80

Unstructured Structured

SharedUnshared

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68

67Global Strategy Unit

Why are we so bad at sharing information? Why are we so bad at sharing information?

Shared information is more likely to be discussed and repeated and this will influence the individuals in the group, and hence influence the group’s eventual outcome.

Social pressure

Cascades

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69

68Global Strategy Unit

Social pressure : Those who conform are rewarded (Wittenbaum et al 1999)Social pressure : Those who conform are rewarded (Wittenbaum et al 1999)

55.2

5.45.65.8

66.26.4

6.66.8

7

Shared Unshared

SelfOthers

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69Global Strategy Unit

CascadesCascades

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

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71

70Global Strategy Unit

Group polarisationGroup polarisation

• 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 feedback into the extremity of view, generally creating a loop of increased confidence in more and more extreme views

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71Global Strategy Unit

GroupthinkGroupthink

A tendency to examine too few alternatives

A lack of critical assessment on each other’s 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

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72Global Strategy Unit

SolutionsSolutions

Secret ballots

Devil’s advocates

Authentic dissent

Respect for other group members

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73Global Strategy Unit

Beware of authority – Milgram experimentsBeware of authority – Milgram experiments

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74Global Strategy Unit

Bandura’s driving forces – turning good people badBandura’s driving forces – turning good people bad

• Moral justification

• Euphemistic labelling

• Advantageous comparison

• Displacement of responsibility

• Diffusion of responsibility

• Disregard or distortion of consequences

• Dehumanisation

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76

75Global Strategy Unit

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DRESDNER KLEINWORT WASSERSTEIN RESEARCH – RECOMMENDATION DEFINITION (Except as otherwise noted, expected performance over next 12 months)

Buy 10% or greater increase in share price Reduce 5-10% decrease in share price Add 5-10% increase in share price Sell 10% or more decrease in share price Hold +5%/-5% variation in share price

Distribution of DrKW equity recommendations as of 1 Apr 2004

All covered companies Companies where a DrKW company has provided

investment banking services (in the last 12 months)

Buy/Add 337 53% 55 57%Hold 188 30% 31 32%Sell/Reduce 108 17% 11 11%Total 633 97

Source: DrKW