Charles Mackay’s ‘Extraordinary Popular Delusions and the Madness of Crowds” remains an all-time classic of market literature. The work dissects the mob psychology behind numerous market bubbles. Mackay has remained influential, but his conclusions have not gone unchallenged. Indeed, there has been an increase in literature concerning with what has been termed “the wisdom of crowds.”
Strangely enough, both views appear to be true. Understanding why this is can offer investors a valuable edge in the market.
From wisdom to madness
Scott E. Page, a social scientist, made a compelling case for the power of diversity in leading to better decision-making and better organization. This power, however, only manifests when there is genuine diversity.
It is true that crowds with heterogeneous knowledge and backgrounds can make better decisions than individuals. Unfortunately, when the crowd’s views and behaviors become homogeneous, that wisdom can swiftly turn to madness.
A greater number of voices is not a good thing in and of itself. Indeed, a crowd of homogeneous sentiment can cause the very madness Mackay warned about so long ago.
Investors should be cognizant of the power of crowds to make good decisions, but they should not allow that knowledge to cloud their own judgment.They must rely on data and good sense, lest they be swept up - and cast down - by the sentiment of the crowd.
Homogeneity drives bubbles and crashes
The process of how crowd wisdom turns to madness is not fully understood, but economist Blake LeBaron offers some key clues. LeBaron built an agent-based model to understand crowding in the market. What he found was fascinating:
“During the run-up to a crash, population diversity falls. Agents begin to use very similar trading strategies as their common good performance begins to self-reinforce. This makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilizing impact on the market. The economic mechanism here is clear. Traders have a hard time finding anyone to sell to in a falling market since everyone else is following very similar strategies. In the Walrasian setup used here, this forces the price to drop by a large magnitude to clear the market. The population homogeneity translates into a reduction in market liquidity.”
Hence, populations that were once cognitively and behaviorally diverse will tend to become more homogeneous as individual members of the population begin to mimic the most successful of their number. This tends to pay off for a while, but ultimately costs them dearly. As soon as a market shock strikes, the homogeneous actors cause a liquidity crisis as they attempt to exit en masse.
This is a highly compelling explanation of why crowd behavior exacerbates crises. It also helps explain how crowds can be both capable of individual-beating wisdom and prone to bouts of extreme madness.
The pressure to conform
There is now broad (if not complete) understanding of how crowds can flip from wise actors to mad ones. But that has not stopped investors from continuing to succumb to age-old pressures to conform and mimic their peers:
“Investors feel the pressure to conform. The CFA Institute surveyed more than 700 investors and found that ‘being influenced by peers to follow trends’ was the behavioral bias that affected decision making the most.”
That is a rather fascinating finding. Professional investors are supposed to be independent thinkers, hunting for alpha while the crowd is distracted elsewhere. Yet even the pros are susceptible to those same pressures. It is perhaps a positive that they are acknowledging the problem. But knowing there is a problem and having the mental wherewithal to overcome it are two different things entirely.
What you can do about it
How can investors overcome their cognitive biases and natural tendencies to move with the crowd? Alas, there is no clear-cut answer to that question. That being said, Benjamin Graham offers one of the best pieces of advice on the subject:
“Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)”
That really is the key point, one that every serious investor should attempt to internalize. Going against the crowd simply to be a contrarian is not a good strategy. Instead, investors should fight to remain continually aware of their own tendencies and biases. Only then can they focus on the facts of reality rather than the fantasies of the crowd.
Disclosure: No positions.
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