Week 36 Day 3: Social Proof: Investment Decisions by Popular Vote

A packed restaurant must be good, right? Usually. A packed stock must be good? Not necessarily. When 'everyone' owns a stock, there are no new buyers left to push the price higher. The most popular stocks are often the most overvalued because all the social-proof-driven buying has already occurred.

Social proof in investment decisions: (1) Fund flows follow past performance. The funds with the highest returns attract the most new money. But high past returns predict lower future returns (mean reversion). Investors pile into last year's winners and exit last year's losers -- buying high, selling low, by following social proof. (2) IPO mania. High-profile IPOs (Facebook, Uber, Airbnb) generate massive demand because 'everyone wants in.' But the average IPO underperforms the market by approximately 3% annually over 5 years (Ritter, 1991). The social proof excitement inflates the price above fair value. (3) Trending tickers. Stocks that are trending on social media (Robinhood, Twitter, Reddit) attract retail buying, which temporarily pushes prices up, which attracts more buyers (positive feedback loop), until it reverses. The stocks that trended on Robinhood in 2021 lost approximately 50% on average over the next 12 months. (4) Asset class popularity cycles. Real estate was popular in 2005-2007 (ended badly). Gold was popular in 2010-2011 (ended badly). Crypto was popular in late 2021 (ended badly). Tech was popular in 1999 (ended badly). Whatever asset class is the 'hot topic' at dinner parties is probably near a peak. The contrarian defense: the most reliable profits come from buying assets that are unpopular. International stocks, value stocks, and small-cap stocks have lagged U.S. growth stocks for years. When the cycle turns (and it always does), the unpopular becomes the profitable.

Social proof (Cialdini, 1984) is one of six fundamental influence principles and operates through both informational channels (others' behavior conveys information about quality) and normative channels (conforming to group behavior provides social belonging). In financial markets, social proof creates informational cascades (Bikhchandani et al., 1992) that detach prices from fundamentals. Empirically, the relationship between social sentiment indicators and subsequent returns is consistently negative: Tetlock (2007) showed that high media positivity (social proof from financial media) predicts low subsequent returns, and Da, Engelberg, and Gao (2015) showed that high Google search volume for a stock predicts negative abnormal returns over the subsequent two weeks. The EDGAR download data shows similar patterns: when more people research a stock (social proof signal), the stock tends to underperform subsequently. Chen, De, Hu, and Hwang (2014) found that Seeking Alpha articles' social sentiment (comments, views, likes) negatively predicts subsequent returns -- the most 'liked' articles are the most crowded trades with the worst forward returns. The mechanism: when social proof drives buying, prices are pushed above fundamental value by the aggregate demand of social-proof-motivated investors. Once the flow of new social-proof-motivated buyers is exhausted (everyone who will buy has already bought), prices revert to fundamental value, generating negative returns for late entrants. For index investors, social proof is largely neutralized: VTI ownership is not driven by social proof signals about individual stocks, and automatic contributions are immune to the trending-ness of particular assets.