‘Everyone does it’ is a risky strategy4 min read . Updated: 21 Dec 2016, 08:07 AM IST
Investing is as much about psychology as it is about the math. It helps to understand why we behave the way we do.
Charles Munger, partner of Warren Buffett and an extremely smart and wise man, talks a lot about avoiding a trap called “social proof". We, as humans, are extremely prone to this psychological phenomenon. “Social proof" drives us to do what others are doing, consciously and unconsciously. This is why a crowd behaves in a similar way. If the people in the crowd are emotionally connected to us (family, friends, peers), then the social proof is even stronger.
Social proof is seen everywhere, including why fads and fashion click, why people follow the crowd’s behaviour when walking on the streets; it is seen as much in investing. In my 25 years of experience in financial services, I have observed that social proof is constantly evidenced in powerful ways. Some examples:
Most people who dealt in cash without paying their taxes were not ignorant of the risk that the government could come down on that stash in many ways—income tax queries, raids, and more.
What happened on 8 November was totally unexpected and a shock to these people. Their default logic was: “I have been doing this for years", “I will deal with the risk as and when it occurs", or “Everyone else is doing it, and they are fine". All these internal stories they are telling themselves are actually not logical. A rational mind would calculate that after paying tax on, say, Rs100 of income, one can earn back the tax paid in 2-3 years b investing in a product that gives a return of 10%. And one can keep earning on the principal for as long as the investment lasts.
Plus, there is peace of mind and the money is safe. However, seeing social proof of others doing the same, people ignore obvious risks.
Some 8 years ago, everyone was booking any property that was launched in Delhi NCR, Bengaluru and even Mumbai. Brokers traded stories of overnight appreciation and entire buildings getting sold out in one day.
A rational mind would pause, think and question the mania. But when, in the cubicle next door, our peer is telling stories of how he negotiated a great price on a flat, one is encounters the doubt whether one is ‘losing out’ on a great investment. The pressure to act under influence of what others are doing is the single biggest factor in the making of a financial disaster. People who would think twice before buying that Rs5,000 shirt were signing cheques worth Rs50 lakh with ease.
A decade ago, the number of parents sending their children to study in a foreign college was about 123,000. Social proof has made this figure grow to 360,000 in 2016. A lot of upper income people feel guilty if they find that they do not have the funds to send their son or daughter abroad to study.
I do not think people are doing a rational evaluation of whether it is worth spending a huge amount or not. Many are merely following social peer norm without considering their own financial stability and future needs. I know many parents who are under tremendous financial stress due to the huge educational loans they have had to take.
The ability for an individual to resist social proof and stick it out with her own decision on investing makes for a lonely journey. It is akin to the journey an entrepreneur may take.
This requires a mind that is practiced in thinking and playing with sound “mental models". It requires temperament and support from family or a business partner. I know of a 50-year-old professional who avoided buying a house for 25 years because he had unpredictable income. This took a lot of pressure off him financially, though he had to change houses a few times. Looking back, he is satisfied with the bank balance he now has while his colleagues have slogged to pay off home loans.
Social proof is also applicable when you see a “hot trend" in business and an extreme form of this trend is an asset “bubble". Venture capital funding crazy sums of money to start-ups made so many people quit their perfectly suited jobs to join a small, uncertain business. As a result, many are encountering disappointment. A mid-cap or small stock that is growing at a furious pace becomes a ‘stock tip’. No one stops and asks: What price am I getting this good company at? Eventually, stock price is the function of the company’s earnings and if one pays too high a price-to-equity multiple, the investment is not going to get great returns.
We all recognise social proof and its pitfalls intuitively. Why then is it difficult to resist? The answer is simple – It is hard work to think deeply, and to act patiently and with discipline. One has to gather data, information, work out the math, learn new principles from different areas. Overall, it requires us to develop sound methods and a checklist to help decide whether one should go with the crowd or be a loner in a particular investment decision.
Many people could have avoided the black money trap had they been more cautious of the risks associated with following the logic “But every one is doing it". Remember, when the risk occurs and you suffer a loss, there is no safety of the crowd. You are alone in your loss.
Rajiv Jamkhedkar, founder and managing director of Serengeti Ventures Pvt. Ltd