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It refers to the fact that many biases are intertwined and thus multiply the simple sum of the initial biases. These inherent tendencies can influence our behavior in either direction. Although the Lollapalooza effect is often portrayed in a bad light, it can have both positive and negative consequences. This cumulative effect amplifies the basic emotional response and sometimes leads investors to make poor portfolio decisions.
But getting rid of our judgments is not easy because they help us simplify our decisions. It is a particularly powerful driver of human behavior. Charlie Munger often mentions this in his talks. Let's see how this effect works and how to avoid it to make better investment decisions.
1 + 1 = 11
The formula is quite clear. The Lollapalooza effect expresses the fact that compound returns also exist in terms of cognitive biases. Adding these biases together is like multiplying the resulting behavioral influence. A bit like stacking cubes.
If we add one cube in width, one in height and one in depth, we don't get four cubes (an addition) but eight cubes (the double). The same thing happens with prejudices and stereotypes when they are combined.
A company's sustainable competitive advantage can be built on the Lollapalooza effect
Charlie Munger cited the global dominance of The Coca-Cola Company in the soft drink market in 1996 as the perfect example of the Lollapalooza effect applied to a company. The ease with which Coca-Cola is available in most stores today (network effect), its advantage in terms of production costs (scale effect), its strong brand synonymous with happiness to be shared (brand effect, availability bias), the social influence that derives from its well-oiled communication, and the fact that it has a large number of customers.(social proof) or the famous secret recipe (which is not really a secret, but it creates a feeling of superior quality and scarcity) have combined to create a real moat (translate as sustainable competitive advantage) for Coca-Cola. Together, these effects increase the company's competitive bulwark tenfold and even create a self-reinforcing virtuous circle. This makes it virtually impossible for a new entrant in the soft drink market to replace Cola-Cola, even with tens of billions of dollars in its pocket.
This is a Lollapalooza effect applied to a business model. But this effect also affects investors in their daily decisions.
Sheepish behavior
The Lollapalooza effect can be applied to investment, leading millions of investors to buy one sector, sell another, or act like real sheep. In this environment, several cognitive biases converge, leading investors to act foolishly and sometimes even contrary to their initial will, if they were alone and acting independently.
This psychological phenomenon known as "social proof" causes people to mimic the actions of others in order to reflect seemingly appropriate behavior. Social proof is a way of dealing with uncertainty. When we are in doubt, we often make decisions by imitating what others do. For example, during a market panic, investors want to sell their assets at any price, not because they think that the fundamentals of the companies have gone down or that their shares are overvalued, but because they have drawn the conclusion that other investors might also sell at the current price.
This herd mentality is the worst enemy of any investor. Blending in with conformity leads to mediocrity. After all, if you sell when everyone else is selling, you'll probably take a huge loss. If you do the opposite and buy when everyone else is selling, you'll probably get great prices for your shares. So, before making an investment, it is wise to think about the different psychological factors that can cause an irrational reaction in the market.
Too much information kills information
Information has never been so widely available through the media and easily accessible by the population. With a simple click, we can know what is happening on the other side of the world. However, this perpetual flow of data, reinforced by the presence of continuous news channels and social networks, clouds our minds and can even make us impulsive in our decision-making.
Firstly, this FOMO (Fear of Missing Out) pushes us to devour the debilitating continuous flow. This disorderly overflow blurs the meaning of events and deprives them of perspective.
Secondly, this media of instantaneity acts as an echo chamber. When we speak, the chamber reflects back to us exactly what we said, like an echo. Algorithms (Youtube and Facebook to name a few), favor content that matches our preferences. Google always has a search result that matches our beliefs. And our confirmation bias takes over. We consume content that we like, that we are "comfortable" with, because it reassures us in our choices. This is why it is so difficult to change our opinion.
Faced with this flood of information and self-reinforcing prejudices through confirmation, it is better to sit back and reflect. Reducing the flow that comes to us, focusing on in-depth articles, confronting different opinions, analyzing the consequences of the most important events, those that are long term and can impact our investments.
The more you read articles (or watch programs) on current events (especially fear mongers), and the more you look at your portfolio and the daily variations of your shares, then you will be more tempted to place frequent orders.
The Lollapalooza effect has been responsible for the success of great companies as well as the most irrational crowds in the markets.
Faced with our biases and prejudices, it might be wise to accept that we don't know, not everything, not all the time. Charlie Munger said "knowing what you don't know is often far more useful than being brilliant".
Be aware of your cognitive biases, the limits of your knowledge zone, the influence that others have on you. Relativize your assumptions, define several investment scenarios, weigh the risk/reward of each position and think for yourself.
Even if "it is as difficult to see oneself as it is to look back without looking back" (Henry David Thoreau), taking the time to analyze one's behavior and emotions in the face of events that happen to us, is already making better decisions.
I would like to finish by quoting Friedrich Nietzsche: "One must still carry chaos within oneself to be able to give birth to a dancing star [...]. In a humanity as advanced as ours, every man by nature has access to many talents. Everyone has an innate talent, but few possess the toughness, endurance and energy to become a talent, that is, to become who they are."
Our prejudices are our chaos. Our willingness to overcome them is the key to making better investment decisions. Learning a little more about the market's behavior every day is also learning a little more about your psychology and developing, if not overcoming, self-control.
