Social Proof and Information Cascades

In the venture world, there’s a lot of talk about social proof. As someone who’s spent a good chunk of his life studying cognition, I know that social proof is one of mankind’s most powerful tools in decision-making. At the same time, we at IA Ventures believe that blindly following social proof is a poor investment strategy (if you can consider it a strategy at all). But how can it be that social proof is both powerful and useless? I think it’s because there are (at least) two conflicting models of “social proof.”

“Independent” Social Proof

I tend to think that when most people see social proof, they assume independent decision-making has taken place. What I mean by “independent” is that each member of the group has reached an independent conclusion about the concept through first-order research. When four different people you respect reach the same conclusion about a concept, that rightly sends a strong validation signal. Because I love diagrams, here’s how this looks:

This is what people seem to believe has happened when they see a list of social proof. However, I think social proof more often conforms to a different model…

Information Cascades

I believe what’s often called social proof is in fact an information cascade. In this schema, one person makes an independent decision about a concept, and others make independent decisions about that first person’s decision. The result is a “cascade” of decisions, each influenced more by the previous decision-maker than by the concept at issue. Here’s the snazzy diagram:

It’s important to note that this behavior is not de facto irrational. Leveraging the judgment and experience of others is one of the most powerful cognitive tools we have. Unfortunately, as time expands and linkages grow, what begins as rational decision-making based on cascaded information can morph into irrational herd behavior.

Identifying Information Cascades

What’s especially frightening about this conflation is how difficult it is to recognize and protect against a transition from rational following to irrational herding. The major complexities I see are:

• Information asymmetry. It’s impossible to divine the basis of an investor’s decision from his or her presence on a list of social proof. Maybe they invested after taking a hard look at the company and drawing an informed decision. Maybe they invested to support another angel. And maybe they invested because they saw the herd and wanted a piece of the slaughter. Who knows?
• Temporal uncertainty. The sequential nature of cascaded information implies a time lag between the first investor’s examination of the business and the second investor’s examination of the first investor’s judgment. Seed stage businesses often evolve three times a day, and twice more at night. In other words, sequential investment decisions are almost necessarily based on the stale judgments of others. 
• Delayed feedback. The most meaningful feedback loop in venture investing (returns) is extremely delayed, often on the order of 7-10 years. In contrast, it only takes a short time to build up a reputation as someone who can be relied on for social proof. Thus, someone whose investment looks like a positive proof point now may in fact be the exact opposite.

There are, of course, many more factors at play in such a boundlessly complex system. These are but a representative sample meant only to illustrate that social proof does not exist in a vacuum.

Conclusion

This whole post of course takes place in the context of the latest AngelList kerfuffle, but I choose not to wade into that particular debate. Rather, I wanted to lay out a few models for thinking in a more nuanced way about social proof and its value as an investment criteria. First-degree social proof is often a rational and intelligent decision, but if you want to understand your risks, it’s essential to understand exactly what type of “proof” you’re relying on.