Social Proof: The herds and investing

We associate herding with animals. Actually, herding is evident in the human world; in business, in the consumer world and particularly in investing.

What is herding and why does it happen?

And why do herds often form on the basis of such little information? Why do herds form even when that information or such behaviour may be mistaken?

The answers to these questions can be found in something called social proof.

What is 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 recognise as “groupthink” (or “risky-shift”) behaviour.

Does this matter? 

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 civilisation.

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.

But just because many are doing a particular thing, does not make it correct.

What’s the proof?

The best-known experiment that showed the concept of social proof was carried out in 1935 by Muzafer Sherif. He put people into a darkroom and showed them a dot of light several feet away. In reality the dot was not moving but, due to the autokinetic effect, it appeared to move to individuals by different degrees.

When asked individually and then in groups how much it moved, individuals deferred to the group estimate even when it was out of line with their experience. Given the movement of the light was ambiguous, Sherif showed that the participants were relying on each other to define a group-informed “reality”.

The evidence suggests that the social proof bias is amplified in complex situations where the “right way” to act is ambiguous yet the importance of being accurate is critical. In the midst of this complexity, the assumption made is that surrounding people possess more knowledge about the situation.

Investing, then, offers perfect conditions for social proof to operate in an exaggerated way, giving rise to the herd behaviour that can drive bubbles and bursts.

Herded investors

When stock markets are falling, there is a strong pull on our emotions as social proof (and loss aversion) encourages an urge to sell if we see others doing so.

Why are others selling? Do they know something we don’t?

The evidence from behavioural finance suggests the answers to these questions could be surprisingly irrational – that people sell because others are selling.

In stock markets, it is clear that herd reactions don’t need rational thought for fuel.

Think long-term

In the long run, stock prices tend to reflect the intrinsic value of companies. In the short-term, however, the market is often a barometer of changing investor sentiment and a reflection of the average view of the players in the market at that moment.

So why would you aspire to follow the average investor?

We know from stock-market holdings data that investors are prone to short-termism – stock-holding periods have fallen significantly since 1985. The evidence suggests that some investors – the Chinese in particular – are more short term than others. We know that stock-market participation has broadened significantly in China in recent years as many individuals have opened trading accounts. While institutions still own most of the market, data suggests these small investors can account for as much as 80% of daily trading on the domestic Chinese exchanges.

This raises the possibility that falls in the Chinese stock markets, triggered by short-termist investors, can trigger sympathetic falls in other markets via social proof and herding.

In today’s synchronised world, it seems like only the first domino need falter to set off a sentimental chain reaction.

Don’t play copy-cat 

Another interesting dynamic to consider is whether there may be large forced sellers in the market. These may or may not be “trend-setters” worth following, yet their large influence on the market could nevertheless trigger trend-following behaviour.

The sovereign wealth funds of large exporters and oil-producing countries, for example, have accumulated large holdings of stocks in recent years. If an oil-producing nation were to sell stocks held in these funds to raise cash due to the hit a lower oil price is having on the government’s fiscal position, and that is instrumental in setting off a decline in stock markets, should investors around the world become nervous? Possibly, but then again perhaps these are investors who are exposed to companies who benefit from a lower oil price?

The market will correct itself 

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.

In the end, the stock market is rational and reflective of human consumption and human endeavor. It’s people, and their tendency to follow the social norm too quickly, which is irrational.

Source
Reproduced with permission of Fidelity Australia

Please note: The advice in this article is of a general nature only and has not been tailored to your personal circumstances. Please seek personal advice prior to acting on this information.

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My Trip to Stanford – A Note From CEO and Founder David Ramsay

I returned last week from my studies in Stanford and would like to share some of my thoughts.

Stanford is the heart of Silicon Valley where the head offices of Google, Facebook and Apple reside. You could say it is the home of innovation.

These days, there are three main narratives impacting investors.

 

Narrative 1: says that Wall Street caused the Global Financial Crisis and that the U.S. Government saved the economy.

Narrative 2: argues that the U.S. is not really in recovery. Anything good happening out there, a rising stock market or falling unemployment rates, is either a bubble or a lie.

Narrative 3: says that the U.S. Government is using Quantitative Easing (QE), TARP and Government stimulus that has created a bubble.

 

What is interesting about all these narratives is that they are all government centric. They ignore the role of entrepreneurship.

In the past seven years, fracking has made the U.S. the most productive energy producer in the world. The cloud, smartphone’s, tablets, apps, 3-D printing, genetic mapping and testing, vertical farming and Big Data are all boosting productivity and profits at company after company.

The Federal Government have never fracked a well or 3-D printed a body part, QE didn’t create the cloud or Big Data, entrepreneurs did.

 

Palo Alto, CA, USA - Sept. 17, 2015: Stanford University Hoover Tower. Completed in 1941, the 50th year of Stanford University's anniversary, the tower was inspired by the cathedral tower in Salamanca, Spain.Palo Alto, CA, USA – Sept. 17, 2015: Stanford University Hoover Tower. Completed in 1941, the 50th year of Stanford University’s anniversary, the tower was inspired by the cathedral tower in Salamanca, Spain.

 

One of those entrepreneurs, Bill Gates, says we are on the verge of 3 amazing technological advances which will be the key drivers in economic growth.

  1. Advanced Robotics – In the U.S. manufacturing between 1993 and 2007 robots accounted for more than one tenth of total GDP growth over this period.

     

     

  2. A Cure for Alzheimer’s – The disease costs the U.S. 230 Billion per year, mostly to Medicare and Medicaid. A cure would immediately alter the budget of every state in the country, not to mention millions of lives.
  3. Super Cement – advances in materials science means for how you build things, how long it lasts, we are going to be able to build infrastructure that lasts 10 times as long as the cement rebar approach that we have today.

 

With all that economic pessimism, it is sure great to have visited the epicenter of innovation. This innovation will continue to provide long term shareholders with a growing income stream to live the lifestyle they desire.

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Why you shouldn’t panic!

Staff Blog

There are times in life where you listen to the news with a heavy heart, and a slight panic.  It’s fair to say the big news stories of the last few weeks have left me feeling this way, following the tragic loss of life in Orlando Florida, and the murder of Jo Cox in the UK.   Label them what you will – hate crime, terrorism – it doesn’t matter how they are portrayed, the reality is that in the global village of today’s world you acutely feel the pain of these events as if they happened down your own street.

As Business Development Manager at Income Solutions, I make sure I keep up to date with the news and read as many articles as I can.  As a Financial Planning firm, we are very interested in behavioural investing and the flow on effect big news events have on the way people view investment markets.

Last week I’ve read articles around SPECULATION of the Brexit outcome – Britain’s decision leave the European Union, for which Jo Cox was passionately campaigning against.  I was horrified to read one article where the author was promoting changing investment options for superannuation investors based on what MIGHT happen.  For example, the author’s suggestion is that the Australian share prices MIGHT be affected by this decision.  The author’s strategy was to sell now while the price is high and then hold cash until it’s right to buy back into Australian shares at a low price.  The author doesn’t predict when that “right time” might be.

NO!  I feel so strongly against this sort of SPECULATIVE advice that I’ll just repeat that.  NO!

Let me give you a definition of speculation, taken from the Macquarie Concise Dictionary: Trading of commodities in the hope of profit from changes in the market price, engagement in business transaction involving considerable risk but offering the hope of large gains.

Now let’s consider your superannuation – a long term INVESTMENT designed to provide you with income when you retire.  From the same source, the definition of investment: The investing of money or capital in order to secure profitable returns, especially interest or income.

Let’s face our own reality.  Unless you are a qualified investment analyst with access to financial reports (which you know how to read and understand), I doubt you have the skill set to know how to time to market.  Event trained and experienced Fund Managers who spend their working week researching and making investment decisions don’t always get it right.  I honestly can’t think of one scenario in 25 years in the industry where I recall a happy outcome.  My over-riding memory of clients who have taken this step is seeing their stress and feeling their loss.

Besides, you seriously have better things to do.

Instead, invest in yourself.  Be the best you can be at your chosen profession or even just life in general.  Set some goals, lifestyle and/or financial, and work hard towards achieving them.  Then outsource – just as most people don’t service their own car or build their own house, your investment decisions should be outsourced to a trusted Financial Planner.  Let your only investment decisions be around how much energy you can place into making your world a better place to live in.  If you can achieve this, by extension of the positive things you are doing, you can contribute towards replacing those heavy news stories with more good news stories.  Even if it’s only the local news.  What’s more, you’ll be spending time enjoying life.

Alison Adams
Business Development Manager

 

Please note: The advice in this article is of a general nature only and has not been tailored to your personal circumstances. Please seek personal advice prior to acting on this information.

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