Saturday, July 11, 2009

The Psychology Of Human Misjudgement: Social Proof

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Humans do as other humans do. This tendency has likely been beneficial throughout Man's history (e.g. in running away from an unseen predator because everyone else is doing it), but it causes some intriguing actions. For example, psychology professors have observed men turning around and facing backwards in elevators after the others (in collusion as part of the experiment) in the elevator have done so. Social-proof tendency has also been frequently used to cause subjects of experiments to make wild measurement errors simply because they trust the group's conclusions more than their own.

Munger sees this tendency often in the business world. When one management purchases a mining company, the competitor's management will seek to follow suit. When several competitors are involved, this often leads to a bidding war and the overvaluation of target companies beyond logic.

Not only negative actions are contagious, however; both good and bad behaviours are copied as a result of social proof. Therefore, Munger stresses the importance for human societies to stop bad behaviour as well as stress/display good behaviour. Furthermore, it is not only actions that serve to perpetuate social proof, but also inaction. Munger sees many companies' boards of directors as excellent examples of copied inaction leading to detriment: many directors fail to object to the group's line of thought until some form of public embarassment has been felt.

Munger finishes his thoughts of this tendency by offering the following advice to readers: "Learn how to ignore the examples from others when they are wrong, because few skills are more worth having."

2 comments:

Chicke Fitzgerald said...

I find this fascinating, particularly as an entrepreneur that spent the better part of the last 3 years raising money for a ground breaking technology in travel, mapping and navigation.

I call it the "sheep" mentality, but social proof is another way to look at it, certainly in this day of word of mouth media.

I have built a relationship ladder describing how to get on the social grid, but I now think I'll modify it to look at what each rung looks like in the world of investing, as I think many investors turn away from opportunities too soon.

In my recent book, Bootstrap Business, I talk about whether early stage ventures are risky because there aren't enough innovative investors or whether investors stay away because they are early stage.

Certainly the behavioral implications that you outline here would indicate that they stay away just because they think others are doing the same thing, irrespective of the reasons.

Anonymous said...

Hi,

I run the Farnam Street website. We're exploring several mental models including Munger's Psychological ones too.

Check it out, perhaps we can collaborate. Keep up the great work.

F. Street

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