Social Proof

Wikipedia defines Social Proof, is a psychological phenomenon where we assume the action of others in an attempt to reflect correct behavior for a given situation. We look for social proof under two conditions.

1. Uncertainty and Doubt
2. Testimonials from “similar others”

In several situations social proof is useful. Before I decided to purchase the book Influence by Bob Cialdini, I looked at the Amazon customer reviews and they were very positive. It was an awesome book and thanks to social proof.

Recently I went to San Francisco,CA and wanted to have some indian food for lunch. I went to yelp.com and went to the restaurant that had better customer reviews. Once again social proof to the rescue.

There are several situations in which depending only on social proof can be disastrous.

In 1992, cable television was newly introduced in Chennai (India). In our locality a new scheme was launched by a company, whose name I do not remember. The scheme is you pay Rs 900/- and you get

1. Cable TV channels forever without any additional charges
2. Free Tiffin Box

Most of the people in our locality signed up for this. I was excited and told my father about it and tried convincing him on why we should also subscribe. He rejected, telling it as a scam. Indeed it turned about to be a scam. The owner of the company ran away with all the money. All the people who subscribed, really liked the Rs 900/- tiffin box!

A simple question of how someone can run the business forever with an upfront cost of just Rs 900/- would have made the scam obvious. Why did they not do? People who were initially unsure looked at others joining and took that as a proof and they joined. Thus social proof turned out to be disastrous. I always wondered why did the company lure people with Free Tiffin Box. I found the answer for that in the book Predictably Irrational – Dan Ariely. Excerpt from the book.

What is about FREE! that’s so enticing? Why do we have an irrational urge to jump for a FREE! item, even when it’s not what we really want?

I believe the answer is this. Most transactions have an upside and a downside, but when something is FREE! we forget the downside, FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it is really is. Why? I think it’s because humans are intrinsically afraid of loss. The real allure of FREE! is tied to this fear. There’s is no visible possibility of loss when we choose a FREE! item(it’s free).

Remember to think on your own, before acting on social proof.

If 40 million people say a foolish thing, it does not become a wise one – Somerset Maugham (British Novelist)

Take a look at this video and can you think why nobody is helping the victim?

This is because of 2 reasons

1. For helping, we should interpret the event as an emergency. When we are uncertain we look at other people around us. If others do not react, we interpret the event as not an emergency. If each person reasons the same way, every one draws the same conclusion(nobody will help). This is called as pluralistic ignorance.
2. The more people there are, the less responsible we feel. If everyone thinks that way, then no one will help. This is called as diffusion of responsibility.

If you are not convinced that a group of people will not help, you should read about the murder of Kitty Genovese. What should we do if we are in such a situation. Excerpt from Influence:The Psychology of Persuasion

Based on the research findings we have seen, my advice would be to isolate one individual from the crowd: Stare, speak and point directly at the person and no one else: “You, sir, in the blue jacket, I need help. Call an ambulance.” With that one utterance you should dispel all the uncertainties that might prevent or delay help.

Pluralistic Ignorance happens a lot in Schools,Colleges and at Work. I have kept quiet several times, even though I did not understand the concept. Why? Since nobody asked any questions, I thought everyone understood and asking a question will make me look stupid. Do not believe me? Watch the video. Believe me you will laugh

In stock markets, IPO is the classic example of social proof in action. Do you think everyone reads the prospectus and then depending on the Return on Capital, Moat of the Business and the Quality of Management purchases the stock in the IPO? I seriously doubt. Everyone looks at similar others and they also jump into action. All you need to come up with stories and they are reinforced nicely by the media.

Reliance Power IPO – 2008

Before the IPO following were stories I heard from my friends. In fact I told this to several other friends.

1. It is a part of Reliance group. It is run by Ambani’s.
2. Ambani’s will not let it fall below the IPO price. So we are safe buying at the IPO price.
3. India is short in power and this company will solve the power problem.

What happened to the stock price? I will let the chart show the results.

Facebook IPO – 2012

Similar stories at a different place(US). The stories that I heard from my friends are.

1. It has over 500+ million users.
2. This is one of a kind and you will miss the opportunity to become rich if you do not participate.
3. One of my friends predicted it will hit $200 on the opening day. A quick math reveals at $200 its market cap will be 484 Billion. How? At $26.68 its Market Cap is 64.51B. Hence at $200 it is ($200 / $26.68) * 64.51B

What happened to the stock price? I will let the chart show the results.

Does social proof affect big shot businessmen?

Yes it does and this is what Charlie Munger has to tell in Psychology Of Human Misjudgment

Big-shot businessmen get into these waves of social proof. 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.

What if I invest my money in actively managed Mutual Funds?

Your fund manager is also a human being. What is the best strategy for him? Buy what other managers are buying. By being conventional he has job security. I got the following quotes from Sanjay Bakshi lectures.

“It really doesn’t matter a lot to me what happens to Johnson & Johnson as long as everyone has it and we all go down together. But on the other hand, he cannot afford to try for large gains on unfamiliar stocks which would leave him open to criticism if the idea fails…”

What does Warren Buffet do?

My idea of a consensus is to look in the mirror.

In the summer of 1979, when equities looked cheap to me, I wrote a Forbes article entitled “You pay a very high price in the stock market for a cheery consensus.” At that time skepticism and disappointment prevailed, and my point was that investors should be glad of the fact, since pessimism drives down prices to truly attractive levels.

Look at this picture before taking any decision solely based on social proof.

Next time before you decide to buy a stock in the IPO, come up with 3 reason why not to buy this stock. Why? Thinking about why not, helps you to avoid the biases caused by social proof.

“All I want to know is where I’m going to die, so I won’t go there.” – Charlie Munger