Modules for Investors
Investment Biases - Part 2
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The Psychology of Social Proof Bias: what will others think
First, we seem to assume that if a lot of people are doing the same thing, they must know something we don't. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof.
Social proof is when people follow the actions of others in an attempt to reflect the “correct” behaviour for a given situation. This urge to conform to established patterns or to follow the lead of perceived authority figures, trendsetters, or simply people “in the know” is the social glue that binds people into a herd. Social proof is the underlying psychological bias that results in what we recognize as “groupthink” (or “risky-shift”) behaviour.
In many aspects of life, this tendency to conform and follow is beneficial. In fact, social proof is one of the key human traits that underpinned our evolutionary move to community-based civilization. The impulse to act like others in the tribe would have been powerful for millennia.
It follows that the operation of social proof is cumulative and carries a reflexive, self-reinforcing momentum. As the effect ripples out across a larger number of people, the size of the herd will multiply, encouraging more people to confirm the assumption that this must be the right way to act.
Why do we need Social Proof?
Why do we act like this? Well, in the past following others or moving in herds is a good survival strategy. It provides a kind of sense of security from predators. To save oneself from animal attacks or to plan to attack animals for food, tribes need to move in groups. Those who acted differently from the group – exited the gene pool. We are the direct descendants of those who copied the others' behavior. This pattern is so deeply rooted in us that we still use it today, even when it offers no survival advantage.
How to avoid being Victim to Social Proof?
1. Know “WHY”
Before falling into any sales pitch or reacting to market news (Good/Bad) you need to understand the WHY behind it. WHY have you invested or should you invest/withdraw, in/from this product? Do you already have some goals where this product is getting fit in or this product made you realize that you need to have some goals, if the latter is true then this is the time to work on your goals rather than making investments.
2. Ask “WHY”
When you are sure of your “WHY”, then now is the time to understand other people’s “WHY”. Now, this is where you need to understand that this is none of your business to know what is happening in other people’s lives. Their reaction may be due to a lot of many reasons better known to them. You can only control your behavior and not theirs.
But yes, if you are being pitched by some salesperson then you should better know WHY he is advising, what he is advising. And also WHY he is advising you? WHY he feels that what he’s advising is good advice for you.
3. Put yourself in a process through Financial Planning
Putting yourself in a Process will eliminate most of the biases; provided that process is backed by a properly structured financial plan which takes into account your risk profile and aspirations.
4. Take help of Financial Planners
You have to have a professional financial planner by your side. A human who understands human emotions, not a machine that does what you want it to do; a human who can counter your thoughts, understands the WHY behind your action and guides you on necessary steps.
Certainly, it seems like social proof can trigger and exaggerate herd behaviour in the absence of rational drivers. Fortunately, there are natural limits to directional herd behaviour as trends fizzle out and sellers become exhausted. At some point, when the gloom is felt to be overdone, a new trendsetter often emerges – the value-driven investor – who may kick off a new herd behaviour that acts in the opposite direction to encourage a rally in stocks.
With all these mini trends and trend-reversals, the job of keeping up with them is nigh-on impossible – the trading costs would also be onerous. It is little wonder then that successful investors all agree on one thing – the benefit of taking a longer-term view.
Now that you know about Social proof bias, it’s only logical that we move on to the next big topic - Hindsight bias: should have done that!! To discover the answer, head to the next chapter.
A Quick Recap
- Social proof is when people follow the actions of others in an attempt to reflect the “correct” behaviour for a given situation.
- The operation of social proof is cumulative and carries a reflexive, self-reinforcing momentum.
- Social proof is one of the key human traits that underpinned our evolutionary move to community-based civilization.