Thursday, April 9, 2015

Social proof is not an investment thesis

“the prices on the market are the ultimate form of social proof”
Charlie Munger

The most common form of this bias is where an investor feels “I have bought 2 stocks and both have gone up by 20%. I told my friends and everyone says I am a good stock picker”. This as you all probably already know is not true. Many a time people look to other people to see what they are doing. Yes this is also called cloning – but blind cloning is also dangerous. You should definitely look at what other successful investors are doing but should understand the investment thesis before taking the plunge. All decisions of any legendary investor are not correct – even Berkshire makes mistakes and Warren Buffett is the first one to report all on each annual report.

Interestingly this is very common in institutional financial investors as well. In 2008 the entire investment community was mesmerized by David Einhorn and his fund Greenlight capital. His book “Fooling Some of the People All of the Time: A Long, Short Story” was selling like hot cakes and everyone was talking about it. The fund I was working for asked everyone to read the book too. Several people said Greenlight was long Porche and short Volkswagen as Porche’s market cap was lesser than its holding in Volkswagen. In October 2008 Porche said that it held almost 43% of VW's equity and had options almost 32% more of Volkswagen. This made VW the most valuable company in the world for a short while because the market expected that as Porche’s VW options were in the money if they called the options there would be a short squeeze. All the funds that put on the trade just because of David Einhorn had the same trade on without their own analysis got bitten. This is an example of social proof bias that lost people several billion Euros.

The best way to avoid this bias by an intelligent investor is to focus on cloning only a few investors who typically take bets that you understand and of course to conduct your own detailed analysis before cloning.

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