A three-bedroom apartment. Two cars. Enough flying miles to send an airline into losses (well almost!). Job with a foreign consulting company. Annual salary of Rs 30 lac…or around 45-times India’s average per capita income. Yet my friend Rohan is not happy.
Whenever I meet him, he is, as I put it, caught on the “work-spend treadmill.”
So, just two days back, when he was showing off his latest purchase, a fourth mobile, and one costing in excess of Rs 45,000, I asked him, “You really need one more?”
“It was selling cheap on Flipkart, and so I bought,” he replied.
I knew that handset was Rs 5,000 cheaper on some other website as my other friend had bought it very recently. But then, how do you explain that to someone who bought stuff not because he wanted it, but because “it was selling so cheap and everyone else was buying like crazy!”
I have countless other stories like Rohan’s, where people bought stuff from Flipkart on its Big Billion Day – not because they needed stuff, but because things were selling cheap (at least that was what Flipkart communicated well) and they wanted to buy because others were buying, and before others could buy what they wanted.
What else justifies that Flipkart did a business worth around Rs 600 crore within a matter of few hours? By the way, its competitor Snapdeal has also managed to sell goods worth Rs 600 crore on its own big sale day.
Now, we know for sure that Flipkart and sellers on its platform would have had to bear huge losses for that day’s sale, but that’s not the point here. What’s more important is how companies – especially in the ecommerce space – use a lethal behavioral bias that is bound to fool a large majority of consumers in buying stuff they need. Things worth Rs 1,200 crore in a few hours!
Well, that bias is known as…
Have you ever been in a situation when you looked at the sky, or at something, just because someone else was staring there? Like in this image below…
I remember playing a few of such pranks during school days, when a group of us friends started looking at the sky and then giggling at passers-by following us in doing so.
It’s another matter that I did not realize then that I was getting the passers-by to indulge in what psychologists call as ‘social proof’.
As per Wikipedia, social proof is…
…a psychological phenomenon where people assume the actions of others in an attempt to reflect correct behavior for a given situation. This effect is prominent in ambiguous social situations where people are unable to determine the appropriate mode of behavior, and is driven by the assumption that surrounding people possess more knowledge about the situation.
In simple words, social proof is all about ‘what-you-think-I-think…what-you-do-I-do”.
Social proof is what is at work in canned laughter – what you hear in comedy shows. The reason such laughter exists is it causes the audience to laugh longer and more often when humorous material is presented and to rate the material as funnier.
In fact, you will hear the laughter even when there’s nothing to laugh about. I propose they add such laughter to business channels as well, so that people stressed hearing the experts can get a few laughs. 🙂
Social proof applies especially to the way we decide what constitutes correct behavior. We view a behavior as more correct in a given situation to the degree that we see others performing it.
Whether the question is what to do with an empty popcorn box in a movie theatre, how fast to drive on a certain stretch of highway, or what to put on the plate at a dinner party, the actions of those around us will be important in defining the answer.
Social proof works to both our advantage and disadvantage. When someone shouts “Bomb!” at a packed theatre, it pays to run with others for safety without being analytical.
Social proof also helps us find books we’ll like (Amazon reviews), restaurants to eat at (Zomato), and places to travel (TripAdvisor).
We don’t make our decisions in a choice vacuum. Our social circles influence our actions and our purchases, and that’s normal.
How Managers Make Decisions
Social proof also works at a bigger level…inside companies. That is what drives most CEOs to act like their peers. So they will acquire companies just because a competitor is doing so. And they will conduct accounting frauds just because many others are doing so!
Here is what Warren Buffett wrote to his managers in September 2006, when his peers in corporate America were all under the spell of social proof to justify their misdoings…
The five most dangerous words in business may be “Everybody else is doing it.” A lot of banks and insurance companies have suffered earnings disasters after relying on that rationale.
Even worse have been the consequences from using that phrase to justify the morality of proposed actions. More than 100 companies so far have been drawn into the stock option backdating scandal and the number is sure to go higher. My guess is that a great many of the people involved would not have behaved in the manner they did except for the fact that they felt others were doing so as well. The same goes for all of the accounting gimmicks to manipulate earnings – and deceive investors – that has taken place in recent years.
You would have been happy to have as an executor of your will or your son-in-law most of the people who engaged in these ill-conceived activities. But somewhere along the line they picked up the notion – perhaps suggested to them by their auditor or consultant – that a number of well-respected managers were engaging in such practices and therefore it must be OK to do so. It’s a seductive argument.
But it couldn’t be more wrong. In fact, every time you hear the phrase “Everybody else is doing it” it should raise a huge red flag. Why would somebody offer such a rationale for an act if there were a good reason available? Clearly the advocate harbors at least a small doubt about the act if he utilizes this verbal crutch.
Social Proof and Stock Market
Social proof also works in stock market investing.
Why do you think most of us are always on the lookout for others’ opinions on online forums on the stocks we own or want to own?
Social proof is the reason you will find most fund managers owing similar stocks in their portfolios. The thinking is – “If I outperform, I will be a star…but if I underperform, I will be like others!”
But then, Somerset Maugham said, “If 40 million people say a foolish thing, it does not become a wise one.”
You will scold your child who misbehaves and then says, “But everybody else is doing it.” Have you ever scolded yourself for investing like everyone else is doing?
Seeing the way things are going on in the stock market, I am sure that day is not far when we would see this…
3 Kinds of Social Proof in Investing
There are three types of social proof that impact investors’ decisions – and that you should be very careful of:
1. Television “Experts”: 24×7 television business channels like CNBC have turned investing into a game of sound bites.
Switch on the channel any time during the day (or night) and you will find talking heads and experts spew out their strategies to making money. Every strategy will be different and each one will promise to make you a lot of money if followed.
I’ve seen a lot of people – even a few otherwise sensible investors – fall prey to such strategies and lose their money and good night’s sleep. They speculated in stocks just because someone on TV, posing as an expert, was speculating on that stock.
It’s a trap, dear friend, to invest in a stock just because an “expert” is doing so. You may know from your personal experience.
2. Peer Investors: I’ve seen a lot of investors get their investment advice at the gym or at work when a friend shares what he or she has been buying.
Interestingly, when people talk about their investments, they usually talk only about their large gains. But, even if those claims are true (and they’re hard to verify), it’s difficult for others to profit on those recommendations because the stocks or mutual funds in question have already gone up.
If you’ve ever read the comments on investing blogs or stock forums, you’ve probably seen similarly smart-seeming peer advice – “I bought this and it doubled!”
Funny, but you never hear about the picks they got wrong, do you?
It’s thus important to avoid reading stock forums and especially picking your stocks from there.
3. Wisdom of the Crowds: When McDonald’s claims “Over 1 Million Served,” the message people take away is that, somehow, such a large number of people couldn’t have made a wrong eating choice. So they must be right.
Stocks and mutual funds are similar. Certain stocks and mutual funds have almost cult-like followings.
The massive hype creates a very positive aura around these investments, but a lot of hype doesn’t mean these are necessarily the best funds to buy at all times.
How Newton Got Fooled
South Sea Company was formed in the United Kingdom in 1711. The company had a monopoly in trade with Spain’s colonies in South America and the West Indies as part of a treaty made after the War of the Spanish Succession.
When investors recognized the potential profits to be made from trade with the gold and silver-rich South American colonies, they bid the South Sea Company’s shares and the shares of similar trading companies to incredible heights in a typical speculative bubble fashion.
The stock of the company rose to 128 pounds in Jan 1720, then 330 pounds in March 1720, 550 pounds in May 1720, 890 pounds in June 1720, and around 1,000 pounds later in the summer.
Though the South Sea Company’s shares were skyrocketing, the company’s profitability was mediocre at best, despite abundant promises of future growth by company directors. Its shares leaped to 1,000 pounds per share by August 1720 and finally peaked at this level before plunging and triggering an avalanche of selling.
By September it was down to 175 pounds, and by December to 124 pounds.
Anyways, Sir Isaac Newton had invested in the South Sea stock before its sharp rise and then came out with a 100% profit in a few months.
However, led by social proof – his friends were making even bigger returns on the stock – he caved in and bought the stock again near its peak, and then all hell broke loose! See this great chart below of Newton’s misdemeanours in the South Sea bubble…
Interestingly, while selling his stock for a 100% profit earlier, Newton said this – “I can calculate the movement of stars, but not the madness of men.”
But he himself gave in to the madness caused by social proof (“Everyone is getting rich!”). So the man whom gravity found, could not understand the gravity in the stock market!
From South Sea to Reliance Power
I remember attending the pre-IPO meet of Reliance Power in early 2008, as the company was coming out with India’s largest IPO ever.
At the dais, alongside Mr. Ambani was a “respected” investment banker who had worked on this public issue. What I heard this investment banker promising to investors and brokers who were attending the meet was shocking.
“The IPO will more than double your money on the listing day!” he announced as if he had seen the future. A large number of people stood up and applauded this statement, and similar other promises made during that meet.
I know of how people sold off their other stocks and assets to apply to the Reliance Power IPO (some were my distant family members!). Everyone wanted to get a pie of the IPO not just because the “stock was expected to double on listing day” but also because “everyone else was also applying”!
When I advised people to avoid the IPO at all costs, I heard statements like…
- “You have lost your head! This is a sure-shot winner.”
- “Everyone would me making money on this IPO, so I don’t want to miss out.”
- “So many people have made money on previous IPOs that I had avoided. Not this one!”
Anyways, what followed is in front of us…
All stock market bubbles – like the one you saw in the Harshad Mehta days, or Ketan Parikh days, the dotcom boom, and the real estate boom – are caused by social proof as everyone wants to act and invest like everyone else.
You must have seen several such instances in your investing life as well, when people around you were buying or selling stocks just because “everyone else was doing so”.
You must have yourself fallen into this trap, haven’t you?
Well, that’s how social proof works in investing. It explains why most of us buy high and sell low (because “most” of us are doing so!).
How Fund Managers Behave
Do you think your mutual fund manager knows a lot and uses only his intelligence to pick up stocks? Well, fund managers are also human beings and are affected by social proof.
Warren Buffett writes…
Most managers have very little incentive to make the intelligent-but-with-some-chance-of- looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)
Here is how a fund manager thinks – “It really doesn’t matter a lot to me what happens to this blue-chip stock as long as everyone has it and we all go down together. But on the other hand, I cannot afford to try for large gains on unfamiliar stocks, which would leave me open to criticism if the idea fails.
This explains why for a very long period, only a handful of mutual funds beat the broader markets. Everyone is trying to do exactly like others are doing and thus most come out with less than average results.
Keep in Mind
How to get over the social proof tendency?
Here is some advice from Peter Bevelin’s amazing book, Seeking Wisdom …
- The 19th Century American poet Ralph Waldo Emerson said: “It is easy in the world to live after the world’s opinion; it is easy in solitude to live after our own; but the great man is he who in the midst of the crowd keeps with perfect sweetness the independence of solitude.”
- What is popular is not always right. If you don’t like what other people are doing, don’t do it. Warren Buffett says: “We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t.”
- Disregard what others are doing and think for yourself. Ask: Does this make sense? Remember the advice from Benjamin Graham, the dean of financial analysis – “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
Basically, if you want to be successful in investing, you got to form your own independent opinions. Learn from vicarious experiences, for that will save you a lot of money.
As far as saving money otherwise is concerned, like not buying things your don’t need, here is a flowchart that can help you.
This has helped me a lot in saving a lot of money by leading me to NOT spend a lot of money on things I now consider frivolous.
Click here or on the image below to download the flowchart. It may not be a perfect one that solves your spending problems, but it has helped me immensely, and thus I am sharing it here.
In the chart, start reading from “Should I spend big money?”
(Want to save the full image? Click on the image above, then right-click, then click “Save image as…”)
I am sure this chart will help you save a lot of money as you begin drawing your Diwali shopping list. 🙂
Finally, remember what Benjamin Franklin said – “Buy what thou hast no need of, and before long thou shalt sell thy necessaries” – which simply means – If you buy things you don’t need, soon you will have to sell things you need.
I have nothing to add.
References and Further Reading
- Extraordinary Popular Delusions by Charles Mackay
- The Psychology of Human Misjudgment by Charlie Munger
- Predictably Irrational : The Hidden Forces that Shape Our Decisions – Dan Ariely
- Seeking Wisdom-From Darwin to Munger – Peter Bevelin
Disclosure: I participate in the Amazon Associates Program, which simply means that if you purchase a book on Amazon from a link on this page, I receive a small commission. The book does not cost you any extra. I give away 100% of the commission for the betterment of the under-privileged.