In the world of investing, maintaining a disciplined approach is often touted as the key to long-term success. However, a subtle yet dangerous phenomenon known as the "normalization of deviance" can undermine even the most carefully crafted investment strategies. This article explores what normalization of deviance is, how it manifests in investment contexts, and what investors can do to guard against it.
What is Normalization of Deviance?
Normalization of deviance is a concept introduced by sociologist Diane Vaughan in her analysis of the 1986 Challenger space shuttle disaster. It refers to the gradual process through which deviant behavior or abnormal practices become accepted as normal within an organization or system. Over time, people become so accustomed to a deviant practice that they no longer consider it as risky or problematic.
How Normalization of Deviance Manifests in Investing
In the investment world, normalization of deviance can take various forms. Here are some examples:
Risk Tolerance Creep: An investor who initially set a conservative asset allocation of 60% stocks and 40% bonds might gradually increase their stock exposure to 70%, then 80%, without reassessing their risk tolerance or long-term goals.
Ignoring Stop-Loss Orders: A trader who routinely ignores their predetermined stop-loss levels, rationalizing that the market will "bounce back," is normalizing deviant behavior that could lead to significant losses.
Overconcentration: An investor might allow a single stock or sector to grow to dominate their portfolio, deviating from diversification principles but justifying it due to past performance.
Margin Creep: Gradually increasing the use of margin or leverage beyond initially set limits, rationalizing that the additional risk is manageable.
Skipping Due Diligence: As an investor gains confidence, they might start skipping thorough research on new investments, relying instead on cursory analysis or "gut feelings."
Real-World Examples
The 2008 Financial Crisis: The lead-up to the 2008 financial crisis provides a stark example of normalization of deviance in the financial sector. Banks and financial institutions gradually relaxed lending standards, created increasingly complex derivatives, and took on higher levels of leverage. Each step deviated slightly from previous norms, but over time, these practices became accepted as "business as usual," ultimately contributing to a systemic crisis.
Long-Term Capital Management (LTCM): LTCM, a hedge fund founded by renowned traders and economists, provides another cautionary tale. The fund's initial success led to a gradual increase in leverage and risk-taking. What started as a relatively conservative strategy evolved into an extremely leveraged position that ultimately led to the fund's collapse in 1998.
The AI Hype Cycle (2022 - ): The explosive growth and hype surrounding artificial intelligence provides a contemporary example of normalization of deviance in investment markets. Following the release of advanced AI models like ChatGPT, AI-related stocks and companies claiming AI capabilities saw dramatic price increases, often disconnected from fundamental business metrics. Investors began accepting higher valuations for AI companies, normalizing financial ratios that would have seemed extreme in previous markets. Due diligence standards relaxed, with many investors buying into AI-related startups and stocks based on hype rather than thorough analysis. Market participants justified these deviations with arguments like "AI is different" or "traditional metrics don't apply to this revolutionary technology." This gradual acceptance of increasingly risky investment behaviors in the AI sector demonstrates how easily the normalization of deviance can occur, even among sophisticated investors, when confronted with exciting new technologies.
The Psychology Behind Normalization of Deviance
Several psychological factors contribute to the normalization of deviance:
Confirmation Bias: Investors tend to seek out information that confirms their existing beliefs, ignoring contradictory evidence.
Recency Bias: Recent experiences are given more weight than long-term historical data.
Overconfidence: Success can breed overconfidence, leading investors to underestimate risks.
Groupthink: In institutional settings, the desire for harmony can override critical thinking.
Guarding Against Normalization of Deviance
Investors can take several steps to protect themselves:
Regular Strategy Reviews: Periodically review your investment strategy and risk tolerance. Ensure your current practices align with your stated goals and risk appetite.
Implement Checks and Balances: Use automated alerts or involve trusted advisors to flag deviations from your investment plan.
Maintain a Decision Journal: Keep a record of investment decisions, including the rationale behind each one. This can help identify gradual shifts in your decision-making process.
Embrace Contrarian Thinking: Actively seek out and consider viewpoints that contradict your current stance.
Set Hard Limits: Establish non-negotiable limits on factors like portfolio concentration, leverage, or loss thresholds.
Continuous Education: Stay informed about cognitive biases and investment best practices.
The normalization of deviance represents a significant but often overlooked threat to investment success. By understanding this phenomenon and implementing strategies to guard against it, investors can maintain the discipline necessary for long-term financial success. Remember, the most dangerous deviations often occur not in large leaps, but through a series of small steps that, over time, can lead far from the original path.
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