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Investing: Loneliness is not a bad thing

Apr 20, 2009

In the previous article on 'confirmation bias' we discussed how analysts and investors have the tendency to selectively look for evidence supporting their notions. In this article, we shall examine another tendency called 'social proof'. What is 'social proof'?
It is a close cousin of the confirmation bias. If confirmation bias implies we pay undue attention to our first impressions, 'social proof' implies we pay undue attention to what others are thinking. We inherently try to conform to the crowd. In very simple terms, it can be called 'herd mentality'.

The reason behind this tendency is easy to understand. Social behaviour was crucial to the survival of early humans. Cooperation is vital to both hunting and agriculture. Hence, we have a tendency to belong to groups. It helps if the group approves of you, which in turn is easier if your opinions and behavior conforms to those of the group.

Examples

  • Open outcry auctions: Before electronic trading was introduced, participants used to trade in open outcry pits. Most auctions, from selling paintings to players in the IPL, still use this method. Participants are likely to be influenced by the fact that the other person is also bidding.

  • Public spaces: While visiting new places, exploring new routes, taking public transportation etc in case of confusion, we observe the behaviour of the crowd and follow suit.

  • Teenage behavior: It is a well known fact that the behaviour of teenagers is influenced to a great degree by their social groups. In fact, it is believed that during the teenage years, social approval is more important than that of parents and other adults.

  • Advertising: Advertisers often use social proof to persuade the prospective buyer. Millions of users, largest circulation figures, 75 years of existence are examples of social proof. The underlying rationale behind celebrity endorsements is also social proof.

  • Mergers & acquisitions: As Charles Munger says, "If one oil company foolishly buys a mine, other oil companies often quickly join in buying mines. So also if the purchased company makes fertiliser."

Avoiding the social proof bias in stock picking

  • Admit: The first step in dealing with biases is to admit their presence.

  • Cultivate independence: One should do one's own reading and thinking to the extent possible. While interacting with others one should exercise care before adopting their viewpoints. As Buddha says, "Believe nothing, no matter where you read it, or who said it, no matter if I have said it, unless it agrees with your own reason and your own common sense."

  • Practice discipline: Insulating yourself from the harmful effects of social proof in investing requires discipline. It is not a coincidence that legendary investor Warren Buffett chose to stay in Omaha far away from New York. He has acknowledged that the discipline of staying away from a torrent of recommendations and tips has improved his investment returns. Even when it comes to valuations, one of Buffett's favourite phrases is "You pay a high price for a cheery consensus."


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