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January 18, 2007

Listen and Learn

Do investors learn more from advice or by observing the actions of others?


When economists explain the concept of social learning, they often use the example of two neighboring restaurants. If one is crowded and the other is empty, potential diners who aren’t familiar with either typically opt for the crowded restaurant, reasoning that it must be the better place.

In essence, these deliberating diners are learning by observing the actions of others. But people also learn from one another more directly by seeking advice. Professor Boğaçhan Çelen, working with Shachar Kariv of University of California, Berkeley, and Andrew Schotter of New York University, wanted to compare the results of these two ways of gaining information — particularly in investment decisions.

“In everyday life, we get information from talking to many people who are experts and many who are not,” says Çelen. “People who are considering buying a mutual fund might ask their friends or family members or coworkers for advice. At the same time, by watching the news and following the markets, they get information by observing the behavior of other investors, and this, too, can influence their decisions.”

To compare the effectiveness of learning by observation and learning from advice, the researchers designed an experiment in which the same information was conveyed through both methods. Moreover, to ensure that the subjects received well-intentioned advice, the advisers were paid for giving correct information — simulating the real-world experience of getting information from a trusted or expert source, such as a family member or a financial adviser. The researchers found that the participants were far more likely to act on advice and, furthermore, that those who learned through advice had a clearer understanding of the information. “The findings showed that people tend to take advice more seriously than simply watching others,” Çelen says. “The nature of asking for advice makes people pay closer attention, and they therefore learn faster.”

Learning from advice is also a better option for investors, who are vulnerable to herd behavior in the markets. Although mass behavior can be rational, the markets occasionally give rise to misguided or panicked herds — as it did during the Internet bubble of the late 1990s, when enthusiastic investors drove prices higher and higher. Or take the case of the competing restaurants. The first few customers may have selected a restaurant at random, yet they inspire others to make the same choice. Those who do so might have gotten a better meal next door.

Advice poses less of a risk of creating a wrongheaded herd, Çelen explains, and more of a chance of creating one that behaves rationally. “When we’re faced with an unknown problem — whether it’s choosing a retirement plan or buying a stock — many of us are driven to seek advice from others,” he says. “It turns out that’s a good instinct to follow.”

Boğaçhan Çelen is assistant professor of finance and economics at Columbia Business School.

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