Weekend Reading: Risks of outsourcing thinking

John Huber writes about the risk of outsourcing thinking in an update on his blog. There is a famous sociological experiment from the 1950s where 75% of the participants denied completely obvious facts that were right in front of their eyes simply because they were told that the rest of their peers chose a different (incorrect) answer. There are many reasons why many financial frauds occur, but Huber thinks one of the main reasons the frauds became so big and lasted so long is that investors primarily relied on the opinions of others. The fact that so many other smart people had already given the company their stamp of approval led to massive outsourcing of original thought. No real due diligence was performed by this investor group. If they had, they would have likely discovered numerous warning signs.

Huber gives one example each of independent thinking and outsourced thinking. During the last financial crisis in September 2008, Ken Lewis (CEO of Bank of America) hired two different banks to provide him with a fairness opinion so that he could buy Merrill Lynch. Lewis badly wanted to buy Merrill. The banks he hired to value Merrill knew this. And those two banks dutifully performed their job, giving Lewis the value he needed to justify the acquisition. So, on the Sunday of the epic “Lehman weekend”, Bank of America decided to pay $50 billion for a company whose equity would have most likely been worthless just two or three days later.

Earlier in the summer, Warren Buffett got a call from Dick Fuld (CEO of Lehman Brothers) late on a Friday evening. Fuld wanted Buffett to invest fresh capital into Lehman. This was before the crisis was in full force, but Lehman was starting to haemorrhage cash and was clearly struggling to survive. Buffett told Fuld he would think about it over the weekend. That same night, Buffett pulled out Lehman’s annual report required by the U.S. Securities and Exchange Commission (SEC) that gives a comprehensive summary of a company’s financial performance and began reading it, making notes in the margin. After a couple of hours, he put the filing down and called Fuld back and told him he wasn’t interested. There was simply too much about Lehman’s books that he didn’t understand and couldn’t figure out, and so he found it too risky and quickly decided to pass. He came to this conclusion on his own after reading a document that was publicly available.

Buffett didn’t make calls to Berkshire CEO’s in the finance industry, he sent no analysts to talk to bankers on Wall Street, and he certainly didn’t read any third party research. He simply pulled up a filing that any one of us could have accessed, and decided to see if the company was worth investing in. One guy outsourced his thinking, and one guy did the thinking for himself.

Huber’s observation is that independent thought is extremely rare, which makes it very valuable. On the other hand, outsourced thinking appears to be pervasive in the investment community, and because of how we’re wired, this dynamic is unlikely to change. Regardless of how convincing the facts are, we are just more comfortable if we can mould our opinion around the opinion of others. Understanding this reality and being aware of our own human tendencies is probably a necessary condition for investment success in the long run.