In the 1950s, psychology researcher Solomon Asch discovered something essential about human nature, and, by extension, about investing. He asked participants in a “vision experiment” to look at lines of various lengths and identify which ones were the same length. An easy task.
But he planted researchers among the participants to suggest incorrect answers. Imagine you’re a college undergrad surrounded by research spies feeding you wrong answers. You thought you knew which lines were the same length, but you might doubt your eyesight at least a little if everyone disagreed with you.
And, in fact, some participants changed their answers even though they could clearly see the truth.
The Power of the Opinions of Others
This effect is called social proof. In a world of social media experts and celebrity endorsements, individuals are increasingly swayed by the opinions of others. “Share this” buttons all over the internet aren’t a coincidence. We’re more likely to do things when we know our friends approve of them.
Social proof can be a good thing. It makes our lives easier by simplifying decisions; it helps us find books we’ll like (Amazon reviews), restaurants to eat at (Yelp), games to play (Zynga) and places to travel (TripAdvisor). We don’t make our decisions in a choice vacuum. Our social circles influence our actions and our purchases, and that’s normal.
Of course, it can also be a bad thing. Trusting others over yourself can get dangerous, especially when there's money on the line.
Investing and Social Proof
What does social proof—and Solomon Asch, for that matter—have to do with investing? Everything.
Studies have shown that, even if investors could make a good investing choice on their own, they’re led to make negative decisions if they see their peers making bad choices. In one study, researchers showed them scary movies to make them a little anxious. Then, they told participants that hypothetical stock prices were falling and asked them to choose whether to sell their shares. Some participants were told that prices were falling because their friends were also scared and selling. Others were told that the stock prices they saw were set by computers. The ones who thought their friends were selling were likelier to sell the stocks themselves.
This has real-world implications. For example, when yields on Italian bonds sank precipitously in November (meaning that there was low investor confidence), other investors jumped on the bandwagon and sold more of their investments because they didn't want to be caught with dud investments. That caused the stock market to plunge even further. This effect compounds on itself and can turn into a downward spiral.
Although we all know that we’re supposed to “buy low and sell high,” people usually have trouble pulling that off because emotions can override pure reason. This was true of investments made by banks in 2008 around the crisis, and it's true of individual investors, who tend to buy high and sell low despite better advice. After all, even if you logically know what's best, it's hard to buy into the market when everyone else is fleeing. You might think: Are all those people really wrong? (The answer is yes, they could be.)
3 Kinds of Social Proof in Investing
There are three types of social proof that impact investors’ decisions—and that you should be particularly wary of:
1. "Expert" Investors
24-7 finance cable stations like CNBC have turned investing into a game of sound bites. Talking heads and pundits get up on stage and talk about their strategies to making money. Thing is, they all have different strategies, and few of them work. This is especially true if you cherry-pick a couple of tips without following an overall strategy that's right for you. Research has shown that instead of following expert picks of hot mutual funds, we’d be better off buying low-cost index funds. For example, over the five-year period ending in December 2008, the S&P 500 performed better than 72% of its actively-managed competitors. Beware the allure of expert investing advice and stock picks.
2. Peer Investors
Many investors get their investment advice at the gym or at work when a friend shares what she’s been buying. Of course, when people talk about investments, they usually boast about their large gains. But, even if those claims are true (and they're hard to verify), it’s difficult for others to profit on those recommendations because the mutual funds in question have already gone up. The market is all about investor confidence and who can jump on the bandwagon before everyone else. So, if your friends have already bought that investment and its value has already gone up, you might be too late. If you’ve ever read the comments on an online investing article, you’ve probably seen similarly smart-seeming peer advice. Funny, but you never hear about the picks they got wrong, do you?
3. Wisdom of the Crowds
When McDonald’s claims “Over 1 Million Served,” the message people take away is that, somehow, such a large number of people couldn’t have been led astray. So they must be right. Mutual funds are similar: The media, investing sites, blog posts and tweets play investing favorites. Certain hot money funds have almost cult-like followings. This massive love-fest creates a very positive aura around these investments, but a lot of hype doesn’t mean these are necessarily the best funds to buy right now.
Social Proof and the Need for Investor Individuality
Social proof is a good way to make purchasing decisions, but not to buy stocks. Unlike taking a vacation, investing often requires doing the opposite of what others are doing. If everyone is buying, the price goes up. By the time you get to the party, it may be too late. If everyone is piling into a certain investment, it’s frequently a good sign that it may have already had its run. Investors want to find opportunities that are undervalued, not funds that have been driven up by a buying frenzy.
For the most part, investors should do their own thinking. Warren Buffett once credited his firm’s decision to headquarter in Omaha, Nebraska as the key to his lifetime of investing success. Far away from New York and the Wall Street scene, he could do his own research. Buffett doesn’t use social proof. But he is proof of what it takes to be a successful investor.
If you want to use social proof as part of your investing, use it to generate ideas, or to identify mutual funds or investing strategies. Just make sure you do your own homework before you snap up the latest "it" anything.
For a crash course on how to make your own smart decisions about your portfolio, check out LearnVest's Investing Courses.
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