Facebook Friends Can Make You Poor

Talk, Talk, Talk

Economists have had an extraordinary new idea. They’ve noticed that people communicate with one another and this has opened up a new line of analysis. Maybe these social interactions are somehow important in investment decisions?

Alright, enough sarcasm. The likely involvement of social interaction in causing the diffusion of investing ideas has been around for a while, but is only now catching up with the social networking phenomena. Behind this lies an insight that’s obvious when you’ve had it, but not before: the better your returns the more likely you are to broadcast your results.

Social Intelligence

In 1976 Nicolas Humphrey made a proposal that, in retrospect, doesn’t sound particularly surprising:

“I argue that the higher intellectual faculties of primates have evolved as an adaptation to the complexities of social living. For better or worse, styles of thinking which are primarily suited to social problem-solving colour the behaviour of man and other primates towards the inanimate world”.

This is the social intelligence hypothesis – the idea that it was the complexity of humanity’s social relationships that drove the evolution of the brain. The basic concept is that people are engaged in an arms race, trying to outsmart their competitors while avoiding being outsmarted, and that this drove evolutionary adaptation favoring our large brains.

More Cheap Talk

Even without the theory to back it up it’s a none too difficult intuition that if we’re built with social interaction in mind then said social interaction is likely to be a factor in making investment decisions. When Robert Shiller looked at the state of play back in 1995 he mused:

“Differences across groups in herd behavior might be explained … in terms of different modes of interpersonal information transmission. Patterns of human conversation imply great selectivity to the kinds of information transmitted within groups”.

As that paper reveals, the idea that “interpersonal information transmission” – people talking to each other – might be a mechanism for causing herding effects was a novel economic suggestion. It’s almost laughable now, but it’s a sign of how recently social explanations of economic behavior have become acceptable. Even so, as recently as 2009 David Hirshleifer and Siew Hong Teoh started their paper on Thought and Behavior Contagion in Capital Markets thus:

“Prevailing models of capital markets capture a limited form of social influence and information transmission, in which the beliefs and behavior of an investor affect others only through market price, information transmission and processing is simple (without thoughts and feelings), and there is no localization in the influence of an investor on others. In reality, individuals often process verbal arguments obtained in conversation or from media presentations, and observe the behavior of others.”

Financial Memetics

At root the idea is that market information isn’t simply transmitted through price, but that ideas – or “financial memes” – are spread through social networks “as a sort of social epidemic” (see: Memes, Money, Madness). It’s exactly what you’d expect from an animal built for optimal social interaction with others of its kind, rather than one designed to monitor pricing signals from artificial markets.

To explain how these memes propagate Hirshleifer has come up with the idea of self-enhancing transmission bias – which is a fancy way of saying that we prefer to talk about our triumphs more than our disasters. This type of conversational bias means that people hear more about other peoples’ investing successes than their failures and are correspondingly converted to active investing. The contagion effect biases the mass of socially interacting investors towards active strategies until some catastrophe occurs – or, as the paper puts it, “the mean return penalty to active trading is too much”.

All this being the case you have to suspect that the impact of social networks on active investing strategies is likely to promote and encourage them, as the transmission of successful trades can be much more rapidly propagated amongst an increasing large network of friends. Indeed, people are likely to congregate to those investors they see as being especially successful, and form larger networks. The focal nodes of those networks are then more likely to demonstrate self-enhancing transmission bias in order to maintain their reputation.

Facebooking

Rawley Heimer and David Simon in Facebook Finance: How Social Interaction Propagates Active Investing looked at the interactions in a Facebook-like social network and found that good short-term performance by traders meant they were more likely to start broadcasting their results with others, and that the more successful they were the more likely their correspondents were to copy them:

“Owing to their preference for higher variance strategies, active investors have more opportunity to broadcast extreme returns and are thus more effective in persuading other investors to adopt their strategies. Upon doing so, investors misguidedly adopt an approach to trading that is more intensive but not necessarily more profitable. This pattern of communication can explain the prevalence of active investing amongst individual investors.”

These results confirm David Hirshleifer’s theory and, into the bargain, suggest why social networks can be hazardous for our wealth. Critically this suggests that more efficient information flow doesn’t necessarily lead to more efficient markets. In fact the exact opposite may occur as self-propagating memes about individual investors’ lucky strategies cause the amplification of investing strategies that might best be described as “bloody stupid”.

Know Your Friends

There is, no doubt, a lot more research in this vein coming as social networking offers a real-world test-bed for this kind of analysis. What it reveals about humanity is, perhaps, even more interesting. Evolution appears to have preferentially equipped us with a talent for tracking and mimicking the behavior of other people over one that causes us to stop and wonder whether what we’re doing makes any sense.

So the next time someone pops up and starts telling you about what a great trader they are ask them what was the last really duff investment they made. Trust needs to be built on solid foundations, not ephemeral interactions with electronic personas over dubious social networks or from (ahem) anonymous bloggers. We need to know our enemies, but we need to know our friends even more, especially if we’re putting our capital where their mouths are.

Related articles:

• Herd of Investors
• Memes, Money, Madness
• The Wisdom of Internet Crowds
• Bacteria, Boids and Market Instability
• Noise, Sentiment and StockTwits
• Sexual Trading
• Idiot Noise Traders

Self-enhancing transmission bias, social intelligence hypothesis added to the Big List of Behavioral Biases.