Investment Decisions, Due Diligence, and Social Proof

Posted by Michael Kitces on Thursday, November 10th, 11:22 am, 2011 in Investments

In the midst of volatile, ambiguous, and uncertain markets, it’s often difficult to know what to do. In such a high stakes environment, we look for any clues that we can find, to figure out whether what we’re doing is “right” or not. Unfortunately, though, this can lead to trouble, as research shows that the methods and tools our brains use to make decisions are not always rational. For instance, sometimes we look to what others around us are doing, to determine whether our own actions are appropriate or not, rather than doing our own due diligence. In many situations, this form of “social proof” can be an effective means to fit into society. In other situations, though, it can potentially lead to herd behavior. Which raises the question – to what extent are our investment decisions as planners influenced by what other planners are doing, instead of our own due diligence?

The inspiration for today’s blog post comes from a recent book I have been reading about the science of how our decisions are influenced, called "Influence: Science and Practice" by Robert Cialdini. I’ve been struck in particular by the discussion about the impact that “social proof” has on our decision-making process. An example may help to illustrate:

In an incident in Singapore in the 1980s, the customers of a local bank began withdrawing their money in a frenzy one day, for no apparent news or reason. As it turned out, though, the reason was surprisingly simple: an unexpected bus strike had created an abnormally large crowd waiting at the bus stop in front of the bank that day. Local bank customers passing by mistook the large bus-waiting crowd for bank customers waiting to make a withdrawal, and consequently got in line themselves to get their money out, assuming that if there was such a huge line in front of the bank, it must be in trouble. Although the waiting bus passengers were simply standing nearby coincidentally, the bank was forced to close soon after opening its doors to prevent an actual bank run!

The above example may seem bizarre, but in reality scientists can document an astonishing number of ways that we make decisions based primarily or solely on the actions of those around us, instead of thinking it out entirely for ourselves. It is the reason, for instance, that television sitcoms still use laugh tracks; even though the laughter is patently false, we nonetheless are more likely to laugh at the jokes in the show when they are accompanied by (fake) laughter. And the concept is not new; the tradition dates back to the early 1800s in Paris, where shows would pay planted audience members to clap, cheer, and shout “Bravo” at the stage, in an attempt to make the audience think that everyone around them was enjoying the show, and that therefore they should enjoy it more, too. It may sound ridiculous, but the practice was so wildly successful, that opera houses actually advertised in the public newspapers for so-called “claqueurs” – and even though the theater-goers themselves saw the ads and knew of the practice, it continued to work.

The research shows that these techniques of social proof – where we look to what those around us are doing to determine what we should do, too – are most influential under two conditions: in highly uncertain and ambiguous situations, and when the people around us (who we look to for “proof” about what we should do) are similar to us.

The reason I was so struck by this research is that it appears to me that the challenges we face as planners in dealing with the highly uncertain and ambiguous stock market present a case-in-point example of where we may look to what other (similar) planners are doing to decide what we should do. The theory of social proof would suggest that if we think everyone else is buying, we do too, and if they’re selling, we would likewise do the same; similarly, if we believe that other planners are “staying the course” then we do, too. Because we see that other planners are staying the course, we take that as proof that what we are doing must be right – because if it was wrong, others would be doing something different, right!? 

The problem, of course, is that if virtually everyone is doing the same thing, and believes it’s right only because they perceive everyone else as doing the same thing, no one may stop to ask whether what they’re doing actually makes any real sense; the only reason we'd be doing something is because the herd is doing it. We substitute our own due diligence – albeit after which we still might make the same decision – for social proof, where we act the way everyone else is acting because there is safety in numbers, even if it creates a giant groupthink effect. Or perhaps a group non-think effect, as the point of the social proof research is that we substitute making decisions based on what others are doing for thinking for ourselves. And as the bank run example illustrates above, when social proof is the dominating paradigm for making decisions, sometimes random outside influences can unintentionally guide us into high impact "herd behavior" actions that materially impact our world, even if we don't at first realize it.

This isn’t meant to be an indictment of planners who choose to stay the course in their portfolios in the midst of volatile markets, even though that seems to be the most common group decision of planners, and a situation where social proof can have a real role. The point is simply that if we’re going to do so, we should be doing so for the right reasons (a conscious and diligent, well-researched decision) and not the wrong reasons (it’s what everyone else is doing, and if they’re doing it, it must be right for me and my clients, too).

So what do you think? Have your investment or other decisions even been impacted by social proof? Would you even notice if they were? Do you look to what your peers are doing with their client portfolios to make decisions about what you should do? Is that a proper form of due diligence itself, or an abdication of due diligence responsibilities?

email

  • http://opendoorinvestments.com Joseph Alotta

    Hi Mike,

    I like this article because everyone else likes it.

    Sincerely,

    Joe.

    PS. Please "like" me on Facebook.

  • Chris

    A recent study of Swedish pension accounts found that returns were negatively affected by herding behavior of people using advisors. Seems that the same buy/sell advice was used used by so many advisors at the same time, that their clients caused their own failure.
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1952850

    • http://www.northernflyer.com.au Fawn

      You have published an awesome site.

Blog Updates by Email

@MichaelKitces Twitter


Out and About

Wednesday, April 23rd, 2014

Understanding the New World of Health Insurance Evaluating Existing Annuities: What Every Adviser Needs to Know @ FPA New Jersey

Thursday, April 24th, 2014

Keynote @ Shareholders Service Group

Monday, April 28th, 2014

Safe Withdrawal Rates: Mechanics, Uses & Caveats @ St. Louis Estate Planning Council

VIEW FULL SCHEDULE