We generally accept something as right when others are also performing it and we also start following the same. When one starts clapping at Drama show, all other starts clapping and join that fellow.
Social proof is the evil behind bubbles and stock market panic. It exists in fashion, management techniques, hobbies, religion and diets. It can paralyze whole cultures, such as when sects commit collective suicide.
It has been seen in students, they select particular stream as their career because their friends or others in their family has select it. They do not focus on what they like, whether that stream is suitable to them or not.
We have seen that when a few streams are in fashion; the majority of students chase that same stream rather focus on their skill or interest. We are a human animal so that human emotions affect our decisions.
Every time social proof does not create trouble. When we decide to go out for dinner and found 2 restaurant from which one has a crowd but other is vacant. Here, we should generally prefer a restaurant with a crowd. Herding becomes particularly useful in ambiguous situations because it simplifies the decision-making process. We should follow the crowd when the decision does not have a huge impact on our financial or in life.
Investment – When few start talking about buying a few equity investments than others also start following it and by seeing them succeed more will join their party. That will result in a bubble or burst.
We follow others without thinking about anything. When we see a few others are doing something then our mind stops giving us logical reasoning. I have met a few people before Covid-19 market panic. They were telling me that I should make the large investment as many mutual funds and PMSs have generated good returns in past. If you will not invest then you will miss out an opportunity. We should not follow what others doing rather should focus on their process. Equity investment has created wealth for people and beats inflation so everyone starts herd towards it without thinking about anything and any level. All the assets class has its merits-demerits so that we need to choose an assets class according to our temperaments rather chasing what others are doing.
Majority of the fund managers also follow social proof. If we see the various scheme of the same categories then the majority of the fund has a similar kind of portfolio. They focus on matching their benchmark return. We can see below portfolio of four different schemes of different AMCs, all those have many common stocks in their top-5 holdings.
For overcoming social proof bias, we need to create our circle of competence and investment process. We need to stick with it and let others do whatever they want to do. For example, if pure cyclical businesses do not fall under our circle of competence then we should avoid it though anyone has bought it. Also, the famous quote of Mr Buffett tells us a lot about overcoming social proof bias.