Monday, April 28, 2014

The Illusion of Consensus

From this CNBC interview of Warren Buffett by CNBC's Becky Quick. In it, Buffett gives a rather blunt description of how boards tend to behave when it comes to compensation:

"I've been on boards for 55 years— 19 public boards— I've never heard of a vote against the compensation plan voted by compensation committee. What happens in a board, I— I think people sometimes have a mistaken notion of how boards act. But— the compensation com— committee comes in, they've worked for a few hours, maybe a few days, they've had consultants. And— and they say, 'We've approved this plan.' I've never yet heard at any of the 19 boards I was on, anybody say in the meeting they were against it. And I've had— heard a few say it outside of the meeting. But— but taking on a committee that's reported, you've assigned— the job to the committee, and they — taking them on it is— is— is a little bit like belching at the dinner table. I mean, you can't do it too often. (LAUGH) If you do, you find you're eating in the kitchen pretty soon."

When asked if he had ever voted yes on something he didn't agree with his reply was "sure".

Some were a bit astonished by these comments. Yet, on some level, this was Buffett describing how group behavior -- even among smart and very capable individuals -- too often is not how we'd all like to imagine it is. Disappointing to some, no doubt, but it's a reminder how hard it can be to combat the tendency.

In a perfect world, I'd like to have heard something more forceful on this subject from Warren Buffett. One reason I'd like to see more is his unique well-earned stature among business leaders and investors. Another reason is that he has offered, on a number of prior occasions, his own critical views in this arena.

This, at least so far, seems a missed opportunity yet, of course, we all must choose our battles. Time will tell how this all plays out.

Still, how this plays out over time deserves great interest from long-term investors (and beyond). Well thought out compensation systems can have a great influence on how competently valuable resources are allocated. These resources are, ultimately, great contributors to living standards. So senior execs have the chance to allocate some rather important resources in a way that, over one or two generations, can lead to vastly different outcomes in terms of living standards per capita and per share wealth.

Pay them well when their actions have materially beneficial long-term effects.

It is the huge rewards for subpar (or worse) and very short-term outcomes that needs to be reined in.

To expand this group behavior tendency just a bit more broadly and beyond compensation, consider the following comments by Professor Robert Shiller during an interview back in 2012. In the interview, he explains why a serious discussion of asset bubbles and the associated systemic risks did NOT come up during Federal Open Market Committee meetings (according to minutes) prior to 2007 and leading up to the financial crisis.

"It is due to 'groupthink', which psychologist, Irving Janis led research on in the 1970s. It refers to how expert groups come together and interact and Janis argued that experts in a group like that are vulnerable to self-censorship – they are all harbouring doubts about a decision that is about to be reached, but view the doubts as something that they cannot articulate in a suitably professional way, so they quiet themselves and it creates an illusion of consensus. I once served on the Federal Reserve Bank of New York advisory committee and I know exactly the feeling. The discourse is at a high and professional level. I tried to bring up my concerns about bubbles. There were no minutes of our meetings but I found it difficult internally – it’s like bringing up astrology at an astronomer's convention."

Shiller goes on to say:

"People should read Janis's book and think about the vulnerability and their moral commitment to stand up and say things..."

and

"If people are aware of the problem, that goes a long way towards reducing it."

The dynamic among experts one might expect to exist is very different from the one that does exist.*

Committees and boards -- a relatively small group -- behave in less than optimal ways at least often enough to matter. The bubbles** themselves -- involving naturally a much larger number of participants -- is another case of less than optimal group behavior.

With bubbles, the group behavior might be of another sort, on a much broader scale, and with entirely different causes, but the expectation or assumption that groups by and large act in sensible ways seems all too easy to disprove.

Shiller actually warned of the stock market bubble in early 2000 and of the housing bubble back in 2005.

Generally, as prior posts have made clear, I'm skeptical of bold macro predictions and near-term market forecasts but that, to me, is very different from pointing out a situation where extreme valuations prevail and the possible consequences.

In addition, Shiller just might separate himself, at least in part, from some other prognosticators via the following:

"I don't have any certainty," he said. "I have a lot of humility" about any prediction.

Some in the prediction business seem to possess too much of the former and too little of the latter.

From this interview with Charlie Munger:

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"


Economic forecasts are just generally, as Buffett has said, "an expensive distraction" that should be ignored.

Making a judgment call on how prices compare to intrinsic business values is one thing; attempting to guess short or even intermediate term stock price action then mostly timing it right, well, that's another thing altogether. 

Buffett also once said:

"...the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children."

Figuring out how price compares to value, and whether it will likely offer an attractive return over a longer time frame, isn't easy but at least -- with some work, sound judgment, and limits correctly considered -- is doable. Timing things -- especially the short-term price moves -- consistently well just isn't. 

Shiller explains that "bubbles are essentially social-psychological phenomena".

He also says that bubbles should be thought of as "speculative epidemics" and adds:

"We know from influenza that a new epidemic can suddenly appear just as an older one is fading, if a new form of the virus appears, or if some environmental factor increases the contagion rate. Similarly, a new speculative bubble can appear anywhere if a new story about the economy appears, and if it has enough narrative strength to spark a new contagion of investor thinking.

This is what happened in the bull market of the 1920's in the US..."

The fact that much of modern finance and economics is built upon an underlying assumption that we're mostly cold, rational actors would be quite comical if it weren't so costly.

Humans are, especially in groups, psychologically speaking rather very much not the creature that some theorists have imagined.

Adam

Related articles:
Nobel Laureate Bob Shiller on Why the Fed Can't Say There's a Housing Bubble
Central bankers need to address problem of 'groupthink', says Shiller

* It's interesting to note that Professor Shiller served on the economic advisory panel to the Federal Reserve Bank of New York from 1990-2004. Well, in this article Shiller explains his behavior while serving on the panel in the following manner: "In my position on the panel, I felt the need to use restraint. While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently, and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be ostracized from the group..." So even when one has an awareness of this kind of group dynamic -- which Professor Shiller I think it's fair to say clearly does -- there's still great susceptibility to it.

** At least if you agree that bubbles even exist. From this interview with Eugene Fama: "I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."
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