To conform is human. During the Stone Age, our ancestors learned to fit in with their tribe. If they didn’t adopt the tribal culture, they were banished. Being banished was essentially a death sentence, so humans learned that fitting in was a pretty solid survival technique. This desire to conform has since baked itself into human biology. Sometimes social proof provides a helpful shortcut when we’re uncertain of ourselves. But, it can also be used to our detriment.
The biggest reasons why we use social proof are uncertainty, similarity, expertise and number. We are prone to use social proof when making investment decisions because the stock market is loaded with these principles.
- Uncertainty – The stock market = uncertainty, nobody has a crystal ball, nobody knows which way the market will move next.
- Similarity – Your friend has had their entire account in FAANG stocks over the past few years. His account is up 2 bijjilion percent. So I should do this with my account too, right? Michael Batnick wrote about why this might not be the best idea. My Friend is Beating Me
- Expertise – There are “financial experts” on TV all day long telling us what we should and shouldn’t be doing with our money. We should listen because they’re experts, right? Ben Carlson wrote about this topic recently. Expert Judgement Or Lack Thereof
- Number – Well if everyone is investing in this area of the market, I should too, right?
Paying attention to outside noise can distract you from what really matters. What really matters is whether you’re on track to meet your goals or not. These outside pressures can lead to overall poor investing behavior.
So how do we combat these pressures and focus on what matters?
The first step is self-awareness. You NEED to know what kind of investor you are.
As Nick Maggiulli said in his post “Know Thy Investing Self”, “Knowing yourself as an investor will be far more important for your long term results than even the most perfect portfolio.”
You also need to be aware of your “why”. Why are you investing this money? For most people their “why” is a comfortable retirement, as defined by their current lifestyle. Making as much money as possible is not a specific enough “why” to truly guide an investment process. Once you have your “why”, you can work backwards to find your “how”.
Which is where the second part of this approach, reasoning from first principles, comes into play. I first heard about reasoning from first principles in a podcast called, Invest Like the Best. Reasoning through first principles is breaking down a problem to the fundamental truths and working your way from the ground up.
Investors need to reason from first principles because as we now know, reasoning through analogy or using social proof is not an ideal way to make investment decisions.
First Principles used in Financial Planning
- the cost of living will increase over time
- neither cash nor bonds keep up with the cost of living
- stocks are the only asset class to outpace the cost of living
- letting compound interest work for you.
So once you have your “why” (dollar amount needed to fund your goal) you can use these first principles to determine what actions to take. Using your specific dollar amount needed you can figure out how much you will need to save each year, what rate your savings will have to compound at and how much time you have to accomplish this all. After that is all fleshed out, then and only then is it time to decide what areas of the market to invest in.
If this sounds like too much for you to handle on your own, get in touch with us. This is what we do for a living!
Successful investors define their destination, know themselves, and reason from first principles. These integral traits help them avoid faulty decision making methods like using social proof.