Is the concept of emergent social behaviors useful in investing and trading? In his January 2020 address to the American Finance Association entitled “Social Transmission Bias in Economics and Finance”, David Hirshleifer discusses social economics and finance, a new field that examines how social processes shape economic and financial behaviors. This field is distinct from: (1) information economics (some people know more than others); and, (2) behavioral finance (people make systematic mistakes). He focuses on social transmission bias, systematic modification of signals or ideas between sender and receiver, as the key element of the new field. He employs five “fables” (models) to illustrate the novelty and importance of such bias. Based on his long experience in behavioral finance and recent/current studies, he concludes that:
- Social transmission bias takes two forms: (1) signal distortion (e.g., hidden motives of the sender); and, (2) selection bias (e.g., senders talk about their good trades, not their bad ones).
- The five illustrative fables are:
- Bandwidth constraints and simplistic thinking (limits on time and effort to communicate ideas for both sender and receiver): the emergent social effect from iterated loss of nuance is extremely simplistic group thinking, to the point that group belief is less accurate than beliefs of isolated individuals.
- Self-enhancing transmission bias (senders are more inclined to tell receivers about successes than failure, and receivers are unaware of this bias): the emergent social effect is general overestimation of investing results, especially for strategies with volatile returns and positive skewness, and consequently widespread adoption of risky strategies.
- Visibility bias and over-consumption (senders who engage in consumption of products and services are more visible than those who do not, and receivers are unaware of this bias): the emergent social effect is normalization of over-consumption and undersaving, especially among the young.
- Biased information percolation, action booms, and price bubbles (social transmission bias, usually positive for senders and negative for receivers, compounds recursively and thereby grows exponentially faster than news arrival): the emergent social behaviors are booms, bubbles, return anomalies and swings in economic sentiment.
- Biased transmission of folk models (often framed in glib memes or naive beliefs about correlations/cause and effect, such as “the trend is your friend” and “buy the dip”): the emergent social behavior is waxing and waning in popularity of models that do not work, dampened over time, per mechanisms in fables 1, 2 and 4.
- More generally:
- Social transmission bias compounds rapidly, such that small biases can drive large emergent social behaviors. Because the driving biases are small and subject to external shocks, emergent behaviors are difficult to predict.
- Explanations based on social transmission bias do not always require mechanisms from behavioral finance such as overconfidence and over-extrapolation.
- Socially emergent behaviors often look very different from individual tendencies, but may create the illusion of a direct individual tendency that does not exist.
- Exploiting a social transmission view of investing behaviors requires new metrics for social interaction, network position and sources of bias.
In summary, investing models that incorporate social transmission biases may support development of attractive investment strategies.
While the address offers ideas that inform investors operating in social networks, it does not cover any specific strategies.
