In today’s guide to investing we discuss Groupthink, a concept developed by social psychologist Irving Janis in 1972.

The term refers to the phenomenon whereby a group will make faulty decisions, because group pressures lead to declines in mental efficiency, reality testing and moral judgments.

In other words, groupthink occurs when groups tend to make irrational decisions and ignore rational alternatives.

A group is especially vulnerable to groupthink when all of its members are similar in background, and the group is insulated from outside opinions.

Groups are also particularly in danger when there are no clear rules for decision making. Scarily, this sounds a bit like the investment community, don't you think?

Characteristics of groupthink

Think about your trading behaviour and mentality. Could you be someone who is vulnerable to groupthink?

Common symptoms of groupthink are:

- Maintaining an illusion of invulnerability
- Being tempted to rationalize poor trades (also known as "cognitive dissonance")
- Believing in the morality of the group, or in the case of the market, investment community sentiment
- Using group stereotypes to guide your decisions
- Feeling the need to maintain an appearance of unanimity
- Ignoring your true gut feelings
- Putting up "mindguards" to blind yourself and the group from negative information.

If you're engaging in the above behaviours, you might be succumbing to groupthink. It's a very tempting thing, after all, to succumb to groupthink when you're in a group or community.

This is especially so when there is a lot of pressure to make a quality decision, which is what the stock market is all about. However, the pressure to make a quality decision can lead to carelessness and irrational thinking.

People suffering from such pressures tend to disregard rational alternatives and feel that, since there is safety in numbers, one might as well act in accordance with the group - even if group thinking may seem faulty to an outsider.

Unfortunately, studies have shown that decisions guided by groupthink have a low probability of achieving successful outcomes.

The market and groupthink

We as investors are in danger of groupthink when we become heavily involved in the investment community emotion of the time - optimism during bullish times, and paranoia and fear during bearish times - and get swept away with this emotion.

Another example can be found in buying and selling behaviour. Groupthink works so that people feel that they have to follow the behaviour of the majority of the group.

It's not an easy thing to stick to your guns on an opinion that is different from the rest of the group. That's why at times - especially volatile times - we'll see a lot of people moving to buy a security at once, or a lot of people hurrying to sell a security.

This is because it's tempting to have your opinion validated by others in the group. And this temptation is never stronger when the market is suffering volatility.

The temptation to become part of a "herding mentality" becomes very strong. Investors are scared of making a bad decision, and scared of acting alone, so they follow the mentality of the crowd.

However, this doesn't mean the herd mentality is right. Sometimes the market will react in an irrational way towards the latest economic news, even if the fundamentals of a company or sector are still strong.

It's important to keep your head in these times; look at the facts, and act as an individual on the facts, and don't succumb to a panic mob mentality.

No one has made it in the market by being swayed by the latest panic-spreading press releases or rumours!

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua