Monday, January 28, 2008

Behavioral Finance – Social Proof

Can you stick to your financial plan when everyone else claims the sky is falling? This is the seventh in a series of posts about common human misjudgments. The series is based on a Charlie Munger speech at the Harvard Law School in 1995.

Why study human behavior in relation to finances?
Recognizing and understanding why people do the things they do, what drives them, and what are innately human tendencies is the first step in overcoming your own self and making sound decisions! We want to make rational, logical decisions, but emotions and irrational tendencies get in the way.

7. Bias from over-influence by Social Proof
Social proof involves doing something or not doing something based on what everybody else is doing. It's also commonly known as going along with the crowd.

Charlie gives a couple of examples. One is the case of a young woman, Kitty Genovese, who was slowly murdered while more than 38 people did nothing to stop it. There were lots of excuses. Maybe the most apathetic was the one who told reporters, “I was tired.” But the fact remained that dozens of people stood by and watched a woman being brutally assaulted for an extended period of time, and did nothing. One of the explanations given is that everybody looked at everybody else and nobody else was doing anything. And so there was automatic social proof that the right thing to do was nothing.

Another example he cites is the run on fertilizer companies by Big Oil. Several years ago one of the large oil companies bought a fertilizer company and then practically every other major oil company ran out and bought a fertilizer company. There was no reason for all these oil companies to buy fertilizer, yet they did what their peers were doing. If Exxon was buying fertilizer then it was good enough for Mobil and so on. It turned out to be a financial disaster for the oil companies.

A more recent example would be the way US financial institutions followed each other into creating the current mortgage crisis. Only one of the major players, Goldman Sachs, managed to steer clear of the stupidity.

And of course, social proof, seems to be the mantra of Wall Street. The street reacts with a herd mentality concerning any and all financial related news. It’s an all out stampede with everyone trying to not be the last one to buy or sell. It takes a ton of courage and patience to hold your ground and stick with your financial plan when everyone else is screaming sell, sell, sell!

Especially in times like these when the talk of doom and gloom is ubiquitous. The pundits continue to argue that this time is different. This downturn is unlike all the other bear markets that we have been through. They say that back then whenever there was a stock market crash or a dip in housing prices, each of those markets were able to snap back rather quickly. But this time they say, it’s not just the market, it’s the whole economy.

The financial institutions are shaken and scared. Their only hope is to instill fear in the consumer in an effort to convince the government to come to their rescue. They have taken a huge gamble and lost and now the rest of the world is swooping in to buy up America at rock bottom prices.

In the end, these new owners will still be willing to give you a loan, but now instead of the US financial sector draining billions out of society (John Bogle refers to it as subtracting value from the economy), it will now go into the pockets of hedge fund managers, mutual fund managers, and bankers, etc. in another country.

For more on personal finance, check out the Carnival of Debt Reduction hosted by My Dollar Plan. My article: My beloved Supra has become a money pit was included in the carnival.

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