The Madness of Crowds

 The incessant intraday stock market struggle between bulls and the bears is what drives market rallies and precipitates market declines. Regardless of the style of analysis or system employed by traders, one primary aim of their trading endeavors is to understand the degree of control held by the bulls or bears at any given time and to predict who should hold power in the near to distant future.

Unfortunately, traders' natural desire to follow the crowds often gets in the way of seeing this clearly. Here we'll take a look at how market psychology and behavioral finance propel bull and bear markets en masse.

KEY TAKEAWAYS

• While individual investors typically like to think of themselves as making independent and objective decisions, they are often at the hidden whim of broader market psychology.
• Crowd behavior in markets has been known for centuries, with various asset bubbles like the famous Dutch tulipmania attributed to the power of the masses.
• Herding behavior can spark large and unfounded market rallies and sell-offs that often lack fundamental support to justify the price action.

The Madness of Crowds

One way to view the market is as a disorganized crowd of individuals whose sole common purpose is to ascertain the future mood of the economy -- or the balance of power between optimists (bulls) and pessimistic (bears) -- and thereby generate returns from a correct trading decision made today that will pay off in the future. However, it's important to realize that the crowd is comprised of a variety of individuals, each one prone to competing and conflicting emotions. Optimism and pessimism, hope and fear—all these emotions can exist in one investor at different times or in multiple investors or groups at the same time. In any trading decision, the primary goal is to make sense of this crush of emotion, thereby evaluating the psychology of the market crowd.

Charles Mackay's famous 1852 book, "Extraordinary Popular Delusions and the Madness of Crowds," is perhaps the most often cited in discussions of market phenomena, from the tulipmania in 17th-century Holland to most every bubble since. The story is a familiar one: an enduring bull market in some commodity, currency or equity leads the general public to believe the trend cannot end. Such optimistic thinking leads the public to overextend itself in acquiring the object of the mania, while lenders fall over each other to feed the fire. Eventually, fear arises in investors as they start to think that the market is not as strong as they initially assumed. Inevitably, the market collapses on itself as that fear turns to panic selling, creating a vicious spiral that brings the market to a point lower than it was before the mania started, and from which it will likely take years to recover.

Understanding Herd Behavior

The key to such widespread phenomena lies in the herding nature of the crowd: the way in which a collection of usually calm, rational individuals can be overwhelmed by such emotion when it appears their peers are behaving in a certain universal manner. Those who study human behavior have repeatedly found that the fear of missing an opportunity for profits is a more enduring motivator than the fear of losing one's life savings. At its fundamental level, this fear of being left out or failing when your friends, relatives, and neighbors seem to be making a killing, drives the overwhelming power of the crowd.

By nature, human beings also want to be part of a community of people with shared cultured and socioeconomic norms. Nevertheless, people still cherish their individuality and taking responsibility for their own welfare. Investors can occasionally be induced into following the herd, whether through buying at the top of a market rally or jumping off the ship in a market sell-off. Behavioral finance attributes this conduct to the natural human tendency to be influenced by societal influences that trigger the fear of being alone or the fear of missing out. 

Another motivating force behind crowd behavior is our tendency to look for leadership in the form of the balance of the crowd's opinion (as we think that the majority must be right) or in the form of a few key individuals who seem to be driving the crowd's behavior by virtue of their uncanny ability to predict the future. In times of uncertainty (and what is more uncertain than the multitude of choices facing us in the trading universe?), we look to strong leaders to guide our behavior and provide examples to follow. The seemingly omniscient market guru is but one example of the type of individual who purports to stand as all-knowing leader of the crowd, but whose façade is the first to crumble when the tides of mania eventually turn.

 

Investors can look to indicators of market sentiment to gauge if market psychology is overwhelmingly optimistic or pessimistic and how those trends change over time.

Choices, Choices, Choices

Due to the overwhelming power of the crowd and the tendency for trends to continue for lengthy periods of time on the basis of this strength, the rational individual trader is faced with a conundrum: do they follow the strength of the rampaging hordes or strike out defiantly with the assumption that their individually well-analyzed decisions will prevail over the surrounding madness? The solution to this problem is actually quite simple: follow the crowd when its opinion jibes with your analysis and cut your losses and get out of the market when the crowd turns against you! Both following the crowd and getting out present their own unique challenges.

The Risks of Following the Crowd

The key to enduring success in trading is to develop an individual, independent system that exhibits the positive qualities of studious, non-emotional, rational analysis and highly disciplined implementation. The choice will depend on the individual trader's unique predilection for charting and technical analysis. If market reality jibes with the tenets of the trader's system, a successful and profitable career is born (at least for the moment).

So the ideal situation for any trader is that beautiful alignment that occurs when the market crowd and one's chosen system of analysis conspire to create profitability. This is when the public seems to confirm your system of analysis and is likely the very situation where your highest profits will be earned in the short term. Yet this is also the most potentially devastating situation in the medium to long term because the individual trader can be lulled into a false sense of security as their analysis is confirmed. The trader is then subtly and irrevocably sucked into joining the crowd, straying from their individual system and giving increasing credence to the decisions of others.

Inevitably, there will be a time when the crowd's behavior will diverge from the direction suggested by the trader's analytical system, and this is the precise time at which the trader must put on the brakes and exit his position. This is also the most difficult time to exit a winning position, as it is very easy to second guess the signal that one is receiving, and to hold out for just a little more profitability. As is always the case, straying from one's system may be fruitful for a time, but in the long term, it is always the individual, disciplined, analytical approach that will win out over blind adherence to those around you.

Going Against the Crowd and Getting Out

A trader's best decisions will be made when they have a written plan that spells out under exactly what conditions a trade will be entered and exited. These conditions may very well be driven by the crowd, or they may occur regardless of the direction in which the crowd is moving. And there will be times when the trader's system issues a signal that is exactly opposite to the direction in which the crowd is moving. It is the latter situation of which a trader must be extremely wary.
In a sense, the crowd is never wrong over the short term. Conducting the necessary due diligence, or thinking like a contrarian, is a much better strategy than succumbing to lemming mentality, especially when irrational exuberance seems to have gripped the market. Extreme optimism often coincides with market tops and extreme pessimism is quite apparent at market bottoms. The obvious point is that these market extremes can only be factually identified after the fact. In other words, with the clarity that only comes with hindsight.

Savvy investors know that the time to sell is when prices are much higher than fundamentals suggest and that the time to buy is when the prices are much lower than is reasonably warranted. Extreme optimism should be viewed in a bearish vein and extreme pessimism should be viewed as bullish, which is the opposite of the way the crowd thinks.

When the crowd is moving in a direction that is contrary to what a trader's system maintains, the trader's best decision is to get out! In other words, the trader should take their profits or realize losses and wait on the sidelines until such time as a positive signal is once again issued by the system. It is better to relinquish a certain amount of potential profit than to lose any amount of one's hard-earned principal.

We Can't Control Everything

Although it is a must, due diligence cannot save you from everything. Studies have found that investors are most influenced by current events—market news, political events, earnings, etc.—and ignore long-term investment and economic fundamentals. Furthermore, if a movement starts in one direction, it tends to pick up more and more investors with time and momentum. The impact of such lemming-like behavior has been made worse in recent years due to an abundance of sensationalist financial, economic, and other news that bombards the sensibilities of otherwise prudent investors. This proliferation of financial media inevitably affects investor psychology and gives birth to lemmings.

Frequently Asked Questions

What do mass psychology and herding behavior mean for markets?

When people are overtaken by the power of greed or fear that becomes rampant in a market, overreactions can take place that distorts prices. On the side of greed, asset bubbles can inflate well beyond fundamentals. On the fear size, sell-offs can become protracted and depress prices well below where they should be.

How can one avoid falling victim to the madness of crowds?

The best way is to make investment decisions that are based on sound, objective criteria and not let emotions take over. Another way is to adopt a contrarian strategy, whereby you buy when others are panicking - picking up assets while they are "on sale", and selling when euphoria leads to bubbles. At the end of the day, it is human nature to be part of a crowd, and so it can be difficult to resist the urge to deviate from your plan. Passive investments and roboadvisors provide good ways to keep your hands off of your investments.

Is crowd psychology in markets a new thing?

No. The "madness of crowds" in markets has been documented going back centuries, as evidenced by the many speculative bubbles and market manias observed throughout history.

The Bottom Line

Remember, the feeling that you are missing out on a surefire opportunity for profit is the most psychologically trying and dangerous situation that you are likely to face in your trading career. Indeed, the feeling of missed opportunities is more taxing than realizing losses—an inevitable eventuality if you stray from your chosen path. This is perhaps the ultimate paradox of trading, that our innate human instinct and desire to fit in with the crowd is also the situation that has led many an individual trader to financial ruin. Never fight the power of the crowd, but always be aware of how your individual decisions relate to the power of those around you.