The age of social proof

Dear investors,

It's hard to watch stock market movements without getting intrigued. At one moment, the opinion prevails that the future is gloomy and, soon after, a feeling of optimism contaminates the markets and generates a new bullish cycle. Sometimes, no event of great relevance happens during this reversal of feelings. It is no coincidence that one of the most famous depictions of the market is Benjamin Graham's allegorical Mr. Market, an emotive figure who, in his bipolar fits, can completely abandon customary rationality and act in ways incomprehensible to an outside observer.

However, this perception conflicts with the fact that the investment market is made up of talented and highly qualified professionals, selected through extremely competitive dynamics. How can this select group of people act in an emotional and irrational way? It is conceivable that some isolated investors make mistakes. But shouldn't the average of everyone's opinions, which ultimately determine the price in the market, reflect the best forecast of the future that it is possible for us to achieve?

This view, which argues for the wisdom and competence of the collective of investors, is the famous theory of efficient markets, which we are so fond of criticizing. How can we label as efficient a market that reduced its view of value for some companies by more than 80% in the space of a year, attributing the adjustment mainly to macroeconomic factors? We see only two types of factors that could cause this level of adjustments: either a macroeconomic catastrophe on the order of magnitude of a nuclear war or a major error in assessing the value of these companies…

Criticism aside, the question remains of how this collective of investors, in fact made up of intelligent and highly educated people, can make mistakes of this order of magnitude. It is extremely important to understand the source of these distortions, so that it is possible to avoid being part of these collective errors. This will be our theme.

the usual suspects

In his famous book “Thinking Fast and Slow”, Daniel Kahneman, winner of the Nobel Prize in economics, describes the existence of two reasoning systems that coexist in every human brain: system 1 is fast and heuristic, responsible for what we call intuition , while system 2 is slow and methodical, responsible for what we understand as classical rationality. The ordering among them is not arbitrary. The answer that comes to mind first is always System 1, while the role of System 2 is to suppress System 1 and reach more precise conclusions about the topic of interest, when time is available and we actively decide to make efforts for this.

System 1's rapid responses are useful in many stressful situations. When you see a runaway car coming towards you, it is more efficient to hide behind a pole than to stand still and analyze the trajectory of the car to judge whether it will really run over you. However, system 1 introduces a series of chronic reasoning errors that are called cognitive biases. We already talked about this in our April 2022 letter, but we will return to the subject to deepen some considerations.

Collective mistakes

Virtually all formal tests of intellectual ability focus on System 2. So when we say that the investor public is made up of intelligent, well-educated people, we are praising their System 2. No doubt these are great qualities, but they do not make this public exempt from the cognitive biases imposed by the system 1. Among the dozens of existing biases, some are particularly dangerous because they are “highly scalable” and potentiated in contexts where there are a large number of people interacting with each other, which makes them potential sources of collective errors. This is the case of social proof bias, in which an individual tends to imitate the behavior he sees in other people around him.

To illustrate what a bias can cause, we bring a curiosity mentioned by Charlie Munger in his brilliant lecture entitled “Psychology of Human Misjudgment”: ants are conditioned to march right behind any other ant that is walking in front of them, a behavior responsible for the formation of the long lines of ants that we have all observed at some point. In most cases, the behavior is effective in coordinating the work of the colony together, but when such a trail happens to become a large circle, the ants remain subject to their instinct to follow the ant in front and may continue marching in circles until the death.

This is a very simplified example of social proof. Our human brains would never fall for such a simple trap, but we are far from immune. In an experiment to test this bias, extras enter an elevator in which the test subject is alone and position themselves with their backs to the door. Soon, the test subject turns away from the door as well, even though it is so unnatural and makes no sense (search for “social proof elevator” on Youtube to watch videos of the experiment). In a more serious and complex example, many attribute the adherence of a large part of the German population to Nazism to the bias of social proof (the film “The Wave”, from 1981, addresses the theme).

Let us now see how this bias acts on the investment market.

The social proof trap

One of the characteristics of social proof bias is that it intensifies in situations of uncertainty and stress. Without a rational analysis to determine how we should act and under pressure, it is instinctive to seek advice from people who convey greater confidence or simply copy what they are doing. This instinct is not unwarranted. In most cases, those who act calmly and confidently really know what they are doing. The problem is that this criterion only judges the appearance and not the quality of the recommendation. An example of this are some “financial market gurus” who have more self-confidence than skill or who, in some cases, give malicious advice in search of their own benefits.

When talking about investment analysis, the problem is aggravated, as there are two types of uncertainties involved: epistemic uncertainties, which could be eliminated with more information and analytical efforts (at least in theory, as it is common for the necessary information not to be accessible ), and random uncertainties, related to completely unpredictable parameters and, therefore, cannot be eliminated. The good investor recognizes that this intractable portion of uncertainties exists, which makes it impossible to have absolute confidence about any investment thesis. Thus, the speech of skilled investors tends to be thoughtful and reflective.

However, there are always those who are willing to speak publicly about uncertain topics with extreme confidence and assertiveness, either because of a lack of awareness of the uncertainties involved or because they know that this type of speech is more efficient for their self-promotion than the more thoughtful style. In both cases, the image of certainty is distorted. However, even distorted, this image attracts those who seek guidance to decide what to do in a situation of uncertainty and stress. This is how the vicious cycles that lead to collective errors begin.

the circle of ants

When there are many uncertainties in the macroeconomic or political scenario or in the context in which a given company operates, it would be appropriate for investors to remain in a state of doubt. However, this state is deeply unpleasant for the human mind. Eliminating it at any cost is even another cognitive bias that leads to inappropriate simplifications of analyses, adopting assumptions without reasonable basis and ignoring faulty points in reasoning. All of this to reach a conclusion, even if forced, that allows you to leave the state of doubt.

Now imagine that this forced deduction is brought to the audience by a self-confident orator, it not mattering whether he believes his speech or whether he is a sophist. For listeners, already looking for a way out of their own state of doubt, the concluding speech adds to the social proof of seeing someone making the point publicly. Less rigorous analysts accept the new point of view first and proceed to propagate it along with its original advocate. As the number of people supporting the thesis increases, the social proof becomes stronger and more and more people are attracted to it. The circle of ants is formed.

Note that, in real cases that gain large proportions, the discourses behind these movements are not usually obviously flawed. Typically, they are elegant reasoning, logically consistent and supported by various facts and real data. However, it is enough to exaggerate the probability of some premises that favor the thesis for the whole thesis to become fragile. Carrying out a diagnosis of this type is not a simple task, especially if most people are endorsing the thesis.

Social Proof 2.0

Before the technology that allowed audio recordings, all musical performances were obviously watched live. This greatly limited the reach and, consequently, the fame that a musician could achieve, no matter how exponent he was in his environment. In contrast, many artists achieve global fame today due to the possibility of distributing their music through the internet easily and at low cost.

Similarly, the existence of social networks has greatly facilitated the publication of any type of discourse. However, as the volume of content created daily is very large, it is necessary to establish some criteria to select what will be propagated as a priority. The logic adopted makes a lot of sense: the contents that are most accepted by the public, measured by the engagement in the publications (likes, comments and shares), are chosen for more intense propagation.

The problem with this selection mechanism is that it benefits the contents that are more attractive to our systems 1, which quickly decide what deserves our engagement or not, before greater weighting by our systems 2. Thus, publications that are more appealing than analytically rigorous they are the ones that go viral more easily on the networks, constituting the modern style of social proof.

Taking it a step further, social networks have become so sophisticated that they select what is shown to you not based on approval ratings from the general public, but based on approval from audiences similar to yours. Thus, you already have a natural inclination to agree with the content shown to you and, from your point of view, most people defend the same lines of thought. It's hard to think of better communications channels than today's social media for creating social proof-driven trends.

If this diagnosis seems more applicable to political discussions than to issues related to the economy and investments, remember the companies that grew explosively in the financial market, promising high returns in a short time, through special methods and secret theses that would be revealed “only ” to anyone willing to pay a symbolic amount… Surely you will be able to think of some names.

the glass half full

The dynamics we describe are undoubtedly negative for the general economy, as they tend to undermine the quality of capital allocation decisions. As a result, the resources produced by human labor are used suboptimally and, ultimately, reduce the material wealth available to society.

Although these consequences brought about by the modern media seem inevitable, we also seek to see the other side of the coin: the market exaggerations created by these macro trends are what generate, from time to time, opportunities to buy shares at prices lower than what is reasonable or, when the exaggerated movement is in the opposite direction, of selling stocks for more than they should be worth.

However, to take advantage of the opportunities generated by collective mistakes, it is first necessary not to give in to the tendency to participate in them. The first step is what we seek to describe through this letter: knowing what collective mistakes happen and understanding the mechanisms through which they develop and contaminate the markets.

From then on, what generated us excellent results over the years was maintaining a strong culture of discipline, methodological rigor and confidence in our own analyses. Based on this, throughout this year, we invested our time in company analysis, instead of following the fashion of projecting the macroeconomic and political future of the world, and we carried out a series of stock purchases at prices that we considered to be very attractive.

What best represents the conviction that we will have good returns on the investments made this year are the contributions of our own capital in the Ártica Long Term FIA, made in the recent past. Despite the stock market rising again recently, we don't know if it's the beginning of a new bullish cycle or if we'll still see falls in the coming months. Short-term movements are part of the random uncertainties and any prediction about them could become a source of errors, along the lines just discussed.

“Learn how to ignore the examples from others when they are wrong, because few skills are more worth having” – Charlie Munger