If you read Part 1 in this series on Robert Cialdini’s wonderful book ‘Influence‘, or even the book itself, I hope you’ve started to notice some of the six key principles of influence all around you. In investment circles, you will witness these mental shortcuts being practiced every day by peers, clients or fellow investors. All of these groups are human beings and because of this, unless we are aware of these things we will practice them ourselves without thinking.
In the last post we discussed the principles of Commitment & Consistency and Reciprocation and how each is relevant to business and investing. We also looked at some methods to ensure they don’t detract from investment performance. In this post we’ll touch on two of the remaining four principles. You’ll notice, like the first two, these principles strike at the heart of investing. They are Social Proof and Authority. Let’s consider each and look at some investment analogies.
We are all social animals and we conduct ourselves in a manner that fits in with others. As a general rule, in everyday life we make fewer mistakes by acting in accord with social evidence than contrary to it. I’m sure you’ve witnessed a situation where someone is looking up at the sky. Not long after, a crowd gathers, doing the same thing. As Charlie Munger has observed “Monkey See, Monkey Do.”
“The otherwise complex behaviour of man is much simplified when he thinks and does what he observes to be thought and done around him.” Charlie Munger
Cialdini tells the powerful true story of a North American doomsday cult which was infiltrated by a few journalists. The cult leader informed his members that their town was to be flooded, however they, as the chosen ones were going to be saved by aliens arriving by spaceship on a forthcoming date.
On the ‘specific’ date at the specified time, not surprisingly, no spaceship turned up. The group seemed near dissolution. As cracks emerged in the believers confidence, the researchers witnessed a pair of remarkable incidents. The cult leader told the members she had received an urgent message from the Guardians stating the “little group had spread so much light that God had saved the world from destruction.” Having previously shunned publicity, the cult leader then at once called the newspaper, to spread the urgent message. The other members followed suit placing calls to media outlets.
So massive was the commitmentto the cult that no other truth was tolerable. The member’s previous beliefs should have been destroyed from the physical reality that no saucer had landed, no spacemen had arrived and no flood had come. In fact, nothing had happened as prophesized.
There was but one way out of the corner for the group. They had to establish another type of proof for the validity of their beliefs: social proof. The fact the leader was still believing let other members also believe.
Social proof is most powerful when we are uncertain. Cialdini notes “when people are uncertain, they are more likely to use other’s actions to decide how they themselves’ should act.” And the principle of social proof is most powerful when we are observing the behaviour of people just like us. Furthermore, the more people that are doing the same thing, the more we’re inclined to believe they must know something we don’t.
In ambiguous situations, there is a tendency for everyone to be looking to see what everyone else is doing. This can lead to a phenomenon called ‘pluralistic ignorance‘; something happens and no one acts; each person decides that since nobody is concerned, nothing is wrong. The inaction of others can be as powerful a guide to action as action itself.
“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,” Robert Cialdini
When it comes to investing, Social Proof is one of the most common, powerful and dangerous influences. Perfect information is unattainable in investing and because of it, uncertainty reigns.
“No matter how much research is performed, some information always remains elusive: investors have to live with less than complete information.” Seth Karman
It’s easy to see why investors are often swayed by the crowd. When prices are rising we look to others behaviour and buy. Conversely when a sell-off ensues, we panic and sell. The tech boom, nifty-fifty mania, and bitcoin are all good examples. More recently, long dated sovereign bond yields went negative around the world. This smacks of ‘pluralistic ignorance.‘
“When speculation gets rampant, and when you’re getting what I guess Charlie would call ‘social proof‘ — that it’s worked recently — people can get very excited about speculating in markets.” Warren Buffett
“The crowd madnesses recur so frequently in human history that they must reflect some deeply rooted trait in human nature. A bull market, for example, will be sweeping along and then something will happen – trivial or important – and first one man will sell and then others will sell and the continuity of thought toward higher prices is broken.” Bernard Baruch
We can overcome the pitfalls of social proof by relying only on the facts and taking the time to think. It is important to recognise that share prices are often a function of the crowd, and crowds are often wrong. In addition, just because a share price hasn’t reacted to some news doesn’t imply it shouldn’t have.
“We focus on the facts of an investment case and ignore the crowd.” Bruce Berkowitz
“You can’t look around for people to agree with you. You can’t look around for people to even know what you’re talking about. You know, you have to think for yourself.” Warren Buffett
“It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success.” Seth Klarman
“You will not be right simply because a large number of people momentarily agree with you… You will be right over the course of many transactions, if your hypothesis are correct, your facts are correct, and your reasoning is correct.” Warren Buffett
“A basic ingredient of outstanding common stock management is the ability neither to accept blindly whatever may be the dominant opinion of the financial community at the moment nor to reject the prevailing view just to be contrary for the sake of being contrary. Rather, it is to have more knowledge and to apply better judgement, in thorough evaluation of specific situations, and the moral courage to act ‘in opposition to the crowd‘ when your judgement tells you you are right.” Phil Fisher
“Learn how to ignore the examples of others when they are wrong; because few skills are more worth having.” Charlie Munger
While acting in concert with the crowd can be disastrous, taking advantage of the crowd can be highly profitable. It’s the social-proof aspect of the public markets that creates mis-pricing opportunities for those who have done the work and can think independently. These opportunities don’t arise in private markets where business or property owners tend to be less emotional and choose the optimal time to sell their asset.
“Auction driven markets have a great quality that tends to undershoot and overshoot underlying value quite significantly. So for example, if I took a dart and threw it at any stock in the New York Stock exchange and look at the 52 week range on it, there will be something like 70 to 130. If I look at a business that’s for sale and I asked the owner of the business what the selling price is, it’s hardly going to move over the year. Maybe +/- 15% at most. So auction driven markets create opportunity to buy when they are cheap and sometimes to sell when they are overpriced.” Mohnish Pabrai
Public market opportunities have a tendency to be contrarian and therefore can make us feel uncomfortable and lonely.
“The ultimately most profitable investment actions are by definition contrarian; you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high). These actions are lonely and, uncomfortable.”Howard Marks
“You have to be willing to have the courage to stand by your convictions and that can be a very lonely place to be at times.” Chris Mittleman
Corporate leaders, Wall Street analysts and Investment Committees are not immune from social proof tendencies. In the former, aggressive corporate takeovers, bidding wars, buybacks at market highs, and mis-aligned incentive structures are often implemented because of what others are doing.
“In the highest reaches of business, it is not all uncommon to find leaders who display fellowship akin to that of teenagers. If one oil company foolishly buys a mine, other oil companies often quickly join in buying mines.” Charlie Munger
Wall Street analysts are just as guilty; better to maintain a view consistent with the other analysts than step out on a limb and make a bold contrarian call. When the whole market loves or hates a stock, it’s hard to think so many smart people are wrong. Better to raise your price target to where the stock is currently trading.
“Man is extremely uncomfortable with uncertainty. To deal with his discomfort, man tends to create a false sense of security by substituting certainty for uncertainty. It becomes the herd instinct. The irony is that the greater the uncertainty, the greater the similarity of predictions, as the experts ‘shout together in the dark’.” Bennett Goodspeed
“Specialist analysts operate in a cocoon, in which they are overexposed to company management and peer analysts and underexposed to what is going on in the rest of the world. Herding instincts may tend to reinforce similar opinions among peer analysts.” Marathon Asset Management
You might be surprised to know that we have been trained from birth to acknowledge that obedience to proper authority is right and disobedience is wrong.
“The essential message [of obedience] fills the parental lessons, the school-house rhymes, stories, and songs of our childhood and is carried forward in the legal, military, and political systems we encounter as adults. Notions of submission and loyalty to legitimate rule are accorded much value in each.” Robert Cialdini
Our obedience takes place is an automatic fashion with little or no deliberation.
Cialdini provides colourful examples where people make irrational decisions and/or unthinkable mistakes because of some authoritative directive. Authority can come in many forms, it could be clothes [a uniform or even a business suit], a title [ie an ‘expert’, a ‘rated analyst’, a PhD, CFA?], or personal trappings of authority [a nice Wall Street Office with an electronic LED ticker behind?].
I can’t tell you the number of times I’ve seen investors make irrational decisions based on some authority figure’s viewpoint. You’ll always find some Wall Street expert predicting the market will crash, the USD/Euro/Yen is going to rally/collapse, gold is going to $3,000 etc .. take your pick. Wall Street analysts are paid to act and sound confident in their forecasts. Its worth noting that the Investment Masters are highly skeptical of forecasts.
“I’d advise you to approach the entire subject of forecasts and forecasters with extreme mistrust.” Howard Marks
Testing a forecasters’ track record from a few years ago can be both enlightening and entertaining.
“Old forecasts are like old news – soon forgotten – and pundits are almost never asked to reconcile what they said with what actually happened.” Philip Tetlock
“One of my greatest complaints about forecasters is that they seem to ignore their own records. The amazing thing to me is that these people will go on making predictions with a straight face, and the media will continue to carry them.” Howard Marks
And never forget, there is always someone who picked the last few winners. The problem is, next time it’s likely to be a different person.
“In both economic forecasting and investment management, it’s worth noting that there’s usually someone who gets it exactly right… but it’s rarely the same person twice.” Howard Marks
“Consumers of forecasting will stop being gulled by pundits with good stories and start asking pundits how their past predictions fared – and reject answers that consist of nothing but anecdotes and credentials.” Philip Tetlock
“Organizations that take the word of overconfident experts can expect costly consequences … however, optimism is highly valued, socially and in the market; people and firms reward the providers of dangerously misleading information more than they reward truth tellers.” Daniel Kahneman
“People are also attracted to the titles and degrees of academics because finance is not a credential-sanctioned field like, say, medicine is. So the appearance of a Ph.D. stands out. And that creates an intense appeal to academia when making arguments and justifying beliefs – “According to this Harvard study …” or “As Nobel Prize winner so and so showed …” It carries so much weight when other people cite, “Some guy on CNBC from an eponymous firm with a tie and a smile.” A hard reality is that what often matters most in finance will never win a Nobel Prize: Humility and room for error.” Morgan Housel
It’s important to get the facts and make up your own mind. Remember, even the world’s best investors are rarely right more than 6 out of 10 times. Analysts and Wall Street experts are likely inferior. Don’t follow them blindly.
“You will not be right simply because important people agree with you.” Warren Buffett
“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos
Authority + Social Proof
Oftentimes the interaction of Authority and Social Proof amplify outcomes. Asset bubbles are a good example.
“Avoid the Pied Piper. Just because someone has been right seven times in a row is no guarantee that number eight will work. When he is finally wrong, the size of the herd will be at its maximum – just as it plunges over the cliff and into the sea. As investors walk in lockstep with the guruover the cliff, a new guru who pointed the way correctly (though only a few listened) is thrust to the forefront. When he too falls, investors will again frantically search for a new guru so as to perpetuate the guru loser’s game.” Bennett Goodspeed
“Groupthink” frequently causes an individual to capitulate to crowd thinking simply because he or she finds it difficult to believe that such a large group of people could be wrong particularly when an authoritative figure lends his or her stature to the proposition. The spread of epidemics and information cascades – where a faulty thesis proliferates by word of mouth like a forest fire leaping from tree to tree, without the validity of the original thesis again being contested – further explains the suppression of the constraints of rational and independent thought.” Frank Martin
As is Bernie Madoff’s ponzi scheme ..
“Bernard Madoff showed, thirteen thousand investors and their advisers didn’t do elementary due diligence because they thought the other investors must have done it.” Ed Thorp
And corporate management disasters…
“In the ambit of social proof, the outside directors on a corporate board usually display the near ultimate form of inaction. They fail to object to anything much short of an axe murder until some public embarrassment of the board finally causes there intervention.” Charlie Munger
“Pressure to meet those numbers any way possible is something all employees feel despite their manager’s denials. The non-verbal signals, the phraseology, the tone, the authority figure syndrome, and the implications of what is said count more than good intentions and assumed ethical parameters.” Marianne Jennings
“Confrontation at a meeting where one side has authority and the other needs the job can breed strange and unintended responses.” Marianne Jennings
It takes courage to think independently, and it takes a lot more of the same to be able to act that way. The concept of Social Proof occurs around us every single day, and being able to run against the tide is something that we know can make us feel uncomfortable and very, very alone. And if you add Cialdini’s concept of Authority to the mix, it only makes us feel worse to work against the herd. If someone with a title and a large sense of self-importance with little in the way of track record is offering conviction on an opinion, it is almost impossible for most of us to go the other way. But this is a key difference between the Investment Masters and the rest of us. Courage to take a different path, humility to know when they’re wrong and a healthy wariness to forecasters and their crystal balls.
It’s a conscious choice; to blindly follow the loudest voices or the biggest crowds, or to actively choose to go on your own, independent path.