Today we take a third lesson from Dr. Cialdini and his book Influence: Science and Practice (2nd Ed., HarperCollins, 1988). In the first lesson, we observed the mental mistakes that can follow from perceptual contrast; in the second, we saw how our penchant for unflagging commitment may push us to fall in love with our worst investments.
A third form of influence that can be detrimental to investment performance is social proof. That is, when “we determine what is correct by finding out what other people think is correct” (110). In general, social proof looks sensible; if one doesn’t know what to do, presumably someone else does, so he should follow another’s cue. As Cialdini notes, “as a rule, we will make fewer mistakes by acting in accord with social evidence than by acting contrary to it” (111). Applied to public security markets, social proof entails respecting the market price of a given instrument. What more social proof do you need than the current market-clearing price? The market has spoken. That’s what the business is worth.
Yet, a fairly basic problem lurks here. Out there in the world some actors know what they are doing, but other prominent actors clearly do not (e.g., Lehman, AIG, Madoff). Of course, it is not easy to discern which is which, but it is clear that if we could follow the savvy smarts and disregard the duds, we would be better off (in life and in investing). For example, if we pay particular attention to how Tiger Woods prepares for and plays golf, we’ll do better than if we follow Wide Moat. And we can confirm this because their results consistently diverge over time. Likewise for investing, if we follow the footsteps of Buffett and train our minds to be like his, we will do better than if we were to follow the Beardstown Ladies. While the principle of social proof pushes us to follow any and all leaders, the truth is that we just need to find and follow a good leader.
Of course, in the markets, this assumes that there are better and worse investors, and that we have some tools to reliably differentiate them. Further, it suggests that the successful investor must have the chutzpah to invest contrary to the majority of market participants when they are wrong.
So how does one resist the tendency to join the crowd? For one, the valuation of a given business should take place, as far as possible, before reading news articles, research reports, and blogs. If one can value a business independently, the hooks of social proof will likely not snare him. Second, one must find a way to reliably distinguish the best investors from the crowd–I give my vote to demonstrated, audited, and long-term results. And third, one must not take the consensus view on a security to be decisive. Given our interest in Sears, it is surprising to us that Sears is the most hated stock whose market cap exceeds $250 million. Of course, today’s consensus may ultimately be correct; crowds can be right. But until the cash flow numbers show even greater deterioration, we’re going to stick with our positions.
Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.