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Wit, Wisdom, Charlie: Elementary Worldly Wisdom from Charlie Munger (Issue #6)

This post is authored by Puneet Khurana, a Safal Niveshak tribesman.

Few years back, while buying a book on Amazon, I ended up buying two more books along with the intended purchase.

It was due to a feature of Amazon, which tells you what other buyers have bought along with the book you are trying to purchase. I never heard of these books earlier but after few more clicks, I was convinced enough to buy and hence my purchase.

Little I knew at that time, that psychologists have a special term for the kind of behavior I just displayed. It’s called…

Social proof tendency
In the articles written earlier in this series, we discussed psychological tendencies like Reciprocity and Liking which are discussed by Munger in his speech and also extensively described by Robert Cialdini in his book. ‘Social proof’ belongs in the same group.

Cialdini writes…

One means we use to determine what is correct is to find out what other people think is correct. We view a behavior as more correct in a given situation to the degree that we see others performing it.

All the behavioral traits which we observe are there for a reason. These traits are very beneficial in certain situations and due to this, over the long period of evolutionary development; these traits have become an integral part of human nature.

Social Proof is no different. This tendency is particularly more prevalent in the state of uncertainty.

When in doubt, follow
In ambiguous situations, human beings are more likely to accept the actions (and inactions) of others. It makes our lives easier and our decisions simple.

We see this helping us in our daily lives. From our selection of books at Amazon to relying on other people’s experience with a particular seller on eBay, we rely on other people decisions to make our own.

Most of the times, these decisions are good and extremely helpful. In fact, in his wonderful work, The Wisdom of Crowd, James Surowiecki argues convincingly that the quality of decisions taken by a group is usually better than the one that a single member of group will make.

He also maintains that given the characteristics like Independence of members, aggregation, diversity of opinion and decentralization, the collective decision of group will be better.

This principle works extremely well when the observed behavior is of the people similar to us.

This was well demonstrated by an experiment in 1960, where the experimenter asked the residents of New York City to return a lost wallet to its owner.

They were highly likely to attempt to return the wallet, when they learned that another New Yorker had previously attempted to do so. But learning that someone from a foreign country had tried to return the wallet, didn’t sway their decision one way or the other.

Marketers know best
Marketers have understood this phenomenon very well. In fact, there are lots of studies arguing that it’s better to use regular people in advertisements rather than celebrities.

There is a visible shift in advertisements where regular people are preferred. It enhances the probability of the product being accepted by the consumers because they are able to relate to similar people more than they can relate to celebrities.

Unilever applied this learning to drastically change the fortunes of its Dove brand by starting “Dove Real Women Campaign”


Another way in which advertisers use this technique is by displaying testimonials from selective customers, who are similar to the target audience and are satisfied with the product.

According to Nielsen’s latest Global Trust report, online consumer reviews are the second most trusted source of brand information.

Car companies usually try to increase their sales by showing happy customers in the advertisements (and simultaneously creating artificial ‘waiting period’ giving an impression that the car is widely accepted by the community in which you live).

Unfortunately, as humans, we don’t only imitate good actions, but we also have a tendency to follow wrong actions and inactions of fellow humans.

‘Bystander effect’ is the direct outcome of following such human inactions. Wikipedia defines it as…

A social psychological phenomenon that refers to cases where individuals do not offer any means of help in an emergency situation to the victim when other people are present.

A very (in)famous example is that of the murder of Kitty Genovese which was witnessed by 38 people in her neighborhood but nobody came forward as evidence.

Various corrupt systems, especially in political and administrative areas, are the direct outcome of this social proof tendency combined with incentives caused bias, where the bad behavior is not resisted and leads to what is now referred to as ‘Serpico Syndrome’, named on an honest cop, Frank Serpico in corrupt NY police department (also brilliantly enacted by Al Pacino in a feature film named ‘Serpico’).

Just like any other human endeavor, social proof is prevalent in business and investing world.

Social proof in business and investing
There are numerous examples of corporate managers copying the actions of their competitors even if it doesn’t fit their corporate strategy. A lot of mindless mergers and acquisitions are a direct outcome of such actions.

The independent board members rarely raise their voices and concerns against the immoral proposals of the management. Incentives combined by the social proof (‘if everyone is silent, why should I speak’) leads to such behavior.

We have something called ‘consensus’ earnings and the people who differ from the ‘consensus’ rarely differ by a large margin.

Isn’t it surprising that an industry with so many extremely qualified and smart people have nearly similar predictions of future?

The portfolios of most of the mutual fund managers are very similar or differ only minutely and very rarely we observe any manager taking a very big and ‘against the consensus’ call.

Keynes captured it well when he said, “It is better for reputation to fail collectively than to succeed unconventionally.”

This herd behavior is like that of lemmings that often follows a fellow lemmings jumping off the cliff and commit mass suicide mindlessly following the other lemmings.


* (Many sources claim this to be a myth popularized by a Walt Disney documentary)

This behavior may have given a rotten image to the lemmings, but no individual lemming has ever received bad press.

Unfortunately many investors decide to behave in a similar way. Nobody loses a job for taking a bad call which is taken by everyone else.

A lot of retail investors also exhibit social proof in their investment decisions. They hold a particular stock because most of the people in their ‘investing groups’ are positive on a stock.

Rationalizing and social proof leads to very similar portfolios. It’s absolutely imperative to have independent thought process while making investment decisions. It’s smart to take ideas from other smart people, but it’s foolish to blindly invest in the idea.

This act of mindless copying also leads to mindless selling in tough times because it’s difficult to buy with ‘conviction’ in tough times (and low prices) when there is no knowledge base to get that ‘conviction’ at the very first place.


Avoiding social proof tendency
So what can we do to save ourselves from the folly?

As always, the advice is simple to give here but difficult to master.

Thinking and acting independently is imperative but the day to day interactions with numerous people and constant bombardment of information and various point of views, makes it a extremely difficult art to master.

Possibly, this explains why Warren Buffett preferred Omaha over New York.

A very useful (but not sacrosanct) principle one can employ is to develop contrarian thinking. Keynes said…

Stock market investing is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority. When you find everyone agreeing with you, change your mind.

But there is an important caution here. Usually, contrarians derive a feeling of comfort when most of the people disagree with them; somehow they use this as a sort of evidence of their correctness.

There is a very fatal flaw in this kind of thinking. And the two masters have warned us in past:

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” ~ Benjamin Graham

“We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t.” ~ Warren Buffett

Objectivity and independent thinking is sacrosanct in investment profession and we must not end up like a lemming with his sacred pledge of following the peers

“If everyone is thinking alike, then somebody isn’t thinking.” ~ George S. Patton

About the Author: Puneet Khurana works with an India focused hedge fund. A student of Prof. Sanjay Bakshi at MDI and a CFA (charter awaited), Puneet is an avid reader of books on investing, finance, psychology, philosophy, physics and various other disciplines.

His investing journey has gone from speculating as a college student to investing based on ‘margin of safety’ principle over a period of 9 years. Currently besides his work, Puneet spends considerable time taking guest lectures in subjects like Investment Management and Business Strategy for MBA students and also training CFA aspirants. He blogs at Pragmatic Investing.

Disclaimer: The views expressed in this post are those of the author only and do not constitute in any way an official position, policy, or pronouncement of his employer.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Thanks Puneet for the excellent article.

    Charlie Munger spoke about another example of Social Proof in the Psychology of Human MisJudgment.

    “Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they’re all gone now, but it was a total disaster.”

    The complete audio of the Charlie Munger speech is available here for free!

    Regards,
    Jana

  2. Anil Jain Shastri says:

    Hi Puneet,
    Thanks for bringing pure gemful thought in layman language.You are doing good job plz keep it on.

    Warm regards
    Anil Jain

  3. R.K.Chandrashekar says:

    That was a real eyeopener. Munger and Buffet are fine examples of people who practiced independent thought and action in the world of investment. We need to have the courage and conviction based on sound principles and go ahead and execute them and not wait for social acceptance.
    Here is an example of someone who stuck his neck out and did exactly the opposite of what everyone else was doing on the stock market in 1929 and profited from it.!
    John F. Kennedy’s father, sold before the 1929 stock market crash and kept millions in profit. Kennedy decided to sell because he overheard shoeshine boys and other novices speculating on stocks.

  4. Thank you.
    Social proof is indeed very well ingrained in us and mostly is helpful.
    From birth to death we just play it out most of the times without thinking and mostly beneficially so.
    In investments and other important things in life it pays to take an independent well reasoned (and if I may add a well discussed – often discussing with others provides new perspectives) view/ action.

  5. Anil Kumar Tulsiram says:

    Thanks Puneet very useful

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