Today I just finished reading Robert Cialdini’s famous book: Influence: Science and Practice.
The book explained human behavior has various “rule of thumb” which are the results of evolution.
Reciprocation – We want to give something back when we received a favor. This principle is behind many marketing and sales campaigns in which a small gift or favor is given to a potential customer to induce their business or loyalty.
Commitment and Consistency – We hate to change our decision or belief once we are committed, especially when we make the commitment public. Our behavior wants to be consistent with what we believe or say we believe. Vice versa, our belief can be gradually changed to be consistent to how we behave. This principle is the reflection of cognitive dissonance in psychology. It is applied a lot in brain-washing techniques used by communist, fascist and religious groups. In investment, it causes us to stick with a losing stock because we are committed to think that it is a winning stock.
Social Validation – We tend to follow what the majority of the crowd do, or we want to be approved by our social group. Viewers will feel that the TV Sitcom is funnier when fake laughs are added. Peer pressures among teenagers have a huge effect on their behavior. In the investment world, we want to follow tips, buzz, hot picks by professionals, etc. In addition, we also like to buy stocks that are popular.
Liking – We tend to say Yes to the people we like. That’s why word of mouth marketing (viral marketing) is so much more efficient. That’s also why a good sales person will try to build rapport with you before he tries to sell you anything. That’s also why we tend to buy the stock we like without doing adequate research.
Authority – We tend to follow orders from higher authority even if the order is obviously wrong and ridiculous. This effect is discovered during the famous Milgram Experiment. It turned highly educated and civilized people into monstrous war criminals during the Second World War. “Simply following orders” is a very scary psychological manipulation. In the investment world, we tend to follow the recommendations of authoritative figures.
Scarcity – We find scarce things more attractive and valuable. This is why diamonds although useless to most people, are much more expensive than clean air. This is more than the supply and demand curves in economics. This is saying, limited supply can created extra demand because people irrationally mis-value scarce things. When investing, we tend to believe scarce information.
These psychological biases are part of human nature. Their effects increase dramatically when there are uncertainties involved because in the lack of better information, we rely more on our instinctive “rules of thumb”.