Social Proof plays a very dominant role in decision making by those people who are not confident & thorough enough about a particular subject. Historically, people have felt safe and confident in following the herd instinct. The more people that display a certain behavior, the more acceptable we think that behavior is. The more people follow a certain idea, the more correct we think that idea is.
Usually, most of the people have expertise in a few domains and hence seek social proof for decision making in other areas. Seeking social proof could be right in some instances but it is usually very dangerous in case of making investment decisions. That’s why more than 80% of people make investments in expensive markets and consequently get substandard returns.
Albert Einstein once said, “What is right is not always popular and what is popular is not always right.”
Let us take a few cases to throw some more light on the subject.
Case 1: In the year 1999, two friends Rajesh and Suresh decided to invest in the stock market. Suresh suggested that they invest in the technology-based stocks because they are hot themes, many people are investing in them and getting superb returns in a few months. But Rajesh was skeptical of the skyrocketing prices without much support from underlying fundamentals and decided not to invest. Suresh went ahead encouraged by other people and invested.
A year later, the bubble busted and the market crashed resulting in huge losses to many investors.
Many people, in order to follow their peers, ignore their own risk profile and tend to take excessive risk which is not suitable for them.
Case 2: During the peak of market euphoria in January 2008; Anil Ambani lead Reliance Power came out with an IPO. The issue price was at INR 450 a share for non-retail investors and INR 430 for retail investors. The IPO was priced excessively high and didn’t justify the worth of assets held by the company. Despite knowing that prices are exorbitant, I was startled to watch that many so called “experts” on media were encouraging people to subscribe for the IPO for “listing gains”.
The euphoria was so high that one housewife named Sunita, like many other housewives, who had no idea about stock markets invested their hard earned savings in that IPO. The idea was to sell it on the day of listing. Blinded by the greed, nobody questioned that if everyone is buying to sell on the listing day, who is going to buy it on a listing day? This led me to ask many of my investors, friends, and acquaintances to stay away from the Reliance Power IPO.
As expected, Reliance Power, which surged 19% to INR 538 at the opening, saw the expectation of a dream debut crashing down within four minutes of listing. Shares plummeted to INR 355 and closed at INR 372. Sadly, the initial four-minute high was the only period the stock would manage to rule above the IPO price till date.
Case 3: The Bull market that started in 2013-14 resulted in astonishing returns in mid and small cap space. Many beneficial investors who confused the chance with skills proclaimed themselves as portfolio managers who could manage other people monies. Business magazines were filled with stories about never seen before young lads who made fantastic returns in mid & small cap space and attributed their success to their skills of stock picking.
In reality, a rising tide lifted even junk stocks to far higher levels. Many operators in connivance with promoters find these scenarios very lucrative to pump and dump the stocks. Many retail investors directed their savings in small-cap stocks based on tips and mislead by historical performance without conducting thorough fundamental research about long term future prospects. We, on the other hand, had started booking profits in mid & small cap space in the period of Dec 2017 to Mar 2018 due to excessive pricing over the worth of assets.
Within the next few months, the share prices crashed resulting in about aggregate 20% loss in mid-cap and more than 30% loss in small caps from their respective peaks.
Many investors, like Suresh and Sunita, tend to conform to the herd behavior. The general notion that the majority is right is not always true. Social proof is one of the strongest forces in investing. These forces are also ultimate drivers of bubbles and crashes in stock markets, real estate, bitcoins etc.
Watch an interesting video on how social proof can force a person to make stupid choices.
To avoid the herd instinct, you should try to insulate yourself from the emotions of the market and make an independent analysis & assessment. You should withstand the psychological pressure and uneasiness of not going with the majority, thereby, minimizing the losses.
In case you have no time and expertise to do your own research, we at Truemind Capital, a SEBI Registered Investment Advisor (RIA), can help you achieve your investment objectives. Since RIAs are barred from earning commissions, there is no conflict of interest in advisory and investment management. Additionally, with a clearly defined investment philosophy, more than a decade of experience in investment research & analysis and a proven track record, we are well positioned to generate higher risk adjusted returns on your investments.
“Whenever you find yourself on the side of the majority, it is time to reform (or pause and reflect).”
― Mark Twain
Also Read: Sometimes inaction speaks louder!