In the last column, I reviewed David MacKay's brilliant early 19th century work, Extraordinary Popular Delusions and the Madness of Crowds. MacKay had described in detail three market bubbles—Holland's 17th century tulip mania, England's 18th century South Seas Trading Co. bubble, and France's 18th century Mississippi Land Scandal. From these MacKay was able to draw inferences as to the psychological nature of market bubbles.
The next great contribution to understanding mass psychology and its impact on financial markets was made by Gustave LeBon who published his seminal work The Psychology of the Crowd in 1893. LeBon holds an interesting place in intellectual history in that he was Emile Durkheim's son-in-law and like his father-in-law, LeBon was a central figure in the Parisian academic world from 1890 to the outbreak of World War I.
LeBon noted two very important characteristics of mass psychology. The first was what he termed “the regressive nature of the crowd.” By this he meant that man's baser instincts were released whenever he was in a crowd. Therefore, a person in a crowd was far more likely to be violent when others were violent. Critical thinking gives way to emotions in a crowd. Crowds are easily manipulated by a crowd's leaders and members of the crowd will do things which would be inhibited when alone or in a smaller group. In his paper, “Group Psychology,” Freud cited LeBon extensively, noting how closely LeBon's idea paralleled his own idea that the anonymity of a group freed an individual from the restraints of his conscience.
LeBon's second important contribution was his use of the simile of the group being like an individual woman. While present day feminists would decry his male chauvinism, what LeBon meant was that rational thinking was replaced by emotionalism in a crowd.
These ideas of LeBon have come to be accepted as gospel in terms of stock market mass psychology. In simpler words, it is believed that market trends are hysterical and are usually carried to emotional extremes. Thus certain groups of stocks come into vogue and see their prices bid to extremes while other groups are unpopular and sell for unrealistically low prices. Of course, the ability to identify such extremes provides an opportunity for above market profits.
Mentioned above was Freud's important paper entitled “Group Psychology.” Freud's intimations about the power of suggestion, the role of identification, and the herd instinct all bear direct relevance to understanding market extremes. These insights help explain why professional money managers are not immune to the herd instinct. It might be expected that Wall Street pros would avoid herd mentality, but actually the professionals seem more susceptible to herd mentality than are individual investors. Warren Buffett and Sir John Templeton, two of the greatest money managers of all time, attributed part of their success to working away from Wall Street where they were removed from the emotional chaos that periodically sweeps the investment community. Back in the 1980s, portfolio mangers in New York City joked that if anyone made up a rumor about what Peter Lynch was doing (Lynch was a Boston-based money manager whose Magellan Fund compounded its growth at 30.9% annually over a 14-year period), that rumor would be known in every corner of Wall Street within 15 minutes.
John W. Schott, M.D., is a member of the Boston Psychoanalytic Society. He is director and portfolio manager at Steinberg Global Asset Management. He also publishes a monthly newsletter on investment psychology, The Schott Letter.
Furthermore half of the managers would have acted on the news.
Freud also stressed the libidinal aspects at work in a group and the forbidden libidinal aspects of money. He was able to anticipate the role of “trophy wives” on Wall Street long before the term was dreamed up.
In conclusion, the implications of MacKay, LeBon, and Freud are that the normal person's normal response in a group is to identify with the group and its goals, then to take on a certain anonymity, and be infected with or swept away by the group's emotions. Since these are the norm, it is only the uncommon person who would act differently. The positive characteristics of such a person are intelligence, independence, maturity, and experience. The negative characteristics of the same person are alienation, suspicion, and perhaps introversion.
The ability to stand separate from the crowd has given rise to a whole school of investing known as contrarian investing. A contrarian investor is one who operates on the premise that the crowd is always wrong. He or she seeks sound stocks currently out of favor in the belief that inevitably they will return to favor. Ben Graham, the father of modern security analysis, summed this up best in his great book, The Intelligent Investor, when he said, “In the short run, the market is a voting machine. In the long run, it is a weighing machine.”