Becoming A Better Investor: The Social Proof Tendency

Charlie Munger, Vice Chairman of Berkshire Hathaway and a legendary investor and businessman, made a list of 25 psychological tendencies that he felt influences the way we think and make decisions. These tendencies, outlined in his book Poor Charlie’s Almanac, are useful when it comes to investing. When we recognise and understand these biases, we can avoid mistakes and become smarter, more rational investors.

This week, we’re analysing the fifteenth tendency, the Social Proof Tendency.

What is it?

The social-proof tendency is sort of like following the crowd, or conforming to what a majority of society is doing, because it is in our nature to do so. According to Munger, “…man’s evolution left him with Social-Proof Tendency, an automatic tendency to think and act as he sees others around him thinking and acting.”

It is a psychological phenomenon where we assume the actions of others reflect the correct behavior for a given situation — and this may make us vulnerable to groupthink and herd mentality. In simple terms, when in doubt, we look to others to decide how to act. This instinct evolved for a reason, because back in the day, following the group was often a survival mechanism.

Munger further says, “The Social Proof Tendency is the tendency to think and act as others around you think and act. It causes people to think they’re right when they’re wrong because everyone else seems to agree.”

How does this tendency play out in the world of investing?

What was a survival mechanism for our ancestors can be detrimental in investing. In the financial markets, this tendency can lead to herd behavior, speculative bubbles, and devastating losses.

The Social Proof Tendency prevents us from thinking objectively and independently, pulling us  into conformity, often at the worst possible times. For example, we may scramble to invest in a certain company because everyone else is doing so. A certain company or sector is seen as attractive and we want to invest because we have FOMO or the fear of missing out, even if we have not studied the fundamentals or looked at the facts.

The opposite is also true, with panic selling being a good example. When something triggers a market crash, some people begin to sell, and more people panic and do the same, assuming that the “group” must know something they don’t. Prices plummet not necessarily because of deteriorating fundamentals, but because social panic spreads like wildfire.

So how can we protect ourselves as investors from this bias?

• Think independently: It’s always good to seek out advice and tips from others, but we should always think for ourselves. We should develop our own investment thesis based on fundamental research. We must ask ourselves whether we would invest in a particular company or asset if no one else was talking about it.
• Get comfortable with contrarianism: We don’t always have to go “against the crowd” for the sake of being different, and downplay the investments a majority of others may be making. But we shouldn't disregard contrarianism, either. We should be willing to disagree about a certain investment when the facts support our view. 
• Limit the noise: There’s an information overload in today’s hyper-connected world, and often, The financial media thrives on amplifying the crowd sentiment. We should be selective about the information we consume. Sometimes, the best move may be to turn off the news and go back to reading company filings.

At the end of the day, investing is not about what is popular — it is about discipline, data, and thinking long-term. As investors, it is important to disengage from always following the crowd, and remaining curious and thinking independently.

Sources

https://novelinvestor.com/charlie-mungers-tendencies-of-human-misjudgment

https://fs.blog/great-talks/psychology-human-misjudgment/

https://medium.com/@DenisBischof/using-mental-models-to-understand-human-behavior-pt-3-charlie-munger-4cac3e61d0ad

https://kuvera.in/blog/charlie-mungers-cognitive-biases-for-investment/

https://www.ricklindquist.com/notes/the-psychology-of-human-misjudgment-by-charlie-munger