The madness of men
‘I can calculate the movement of stars, but not the madness of men’.
Isaac Newton (apparently said after he lost his fortune).
The importance of this is not the quote itself.
The importance is that Newton learned the lesson the hard way – that is, after he lost his fortune.
As they say, the stock market is an expensive place to learn about yourself.
And we learn these lessons, unfortunately, when we ignore our critical faculties and simply follow the crowd.
Can the crowd be right?
In 2005, James Surowiecki wrote a book entitled The Wisdom Of Crowds, where he put forward the argument that collective knowledge from a large crowd can be superior to the knowledge of any one individual.
This can indeed be the case!
For example, he showed that when it came to guessing the weight of a cow, the average of everyone’s individual estimations was closer to the real weight than any one individual.
What Surowiecki was explaining is called the normal distribution, better known as the bell curve.
This ‘wisdom’ worked when:
• There was a diversity of opinion;
• People’s opinions are not influenced by the opinion of those around them; and
• People have access to the same knowledge
Now it’s important to ask ourselves whether these criteria apply to markets and whether we can leverage this to make solid investment returns.
Long term vs. short term
Ben Graham famously said that in the short term the stock market was a voting machine (meaning a popularity contest where everyone chases the more popular stocks), while in the long term it’s a weighing machine (meaning everyone becomes rational and sees the real value of each stock).
In other words, things go according to the popular vote until we each come to our senses and rationality returns to the market.
While it’s fair to say there is a certain level of wisdom in crowds, this is applicable only over the long term.
There are plenty of studies showing that in the short term the stock market has momentum (the voting bit) and in the long term it has mean reversion (the weighing bit).
Yes, markets may drift for a while, but generally they’re either in momentum mode or mean reversion mode.
And given the level of valuations presently, and the results from the recent few years, we think it’s pretty accurate to say we’ve been in momentum mode!
You only need to glance at the stock prices for companies such as Tesla and other unicorns to see that the market is voting, not weighing.
This momentum stems from many folks thinking the same thing.
There’s definitely a lack of the 3 criteria mentioned above for drawing any wisdom from the market at the moment!
Social physics (safety in numbers)
How can we derive some wisdom from collective behaviour where, like in the stock market, everyone seems to be on the same side of the boat?
Social physics attempts to explain collective behaviour using just a few simple rules governing individual behaviour.
Even though we all, as individuals, have free will, we’re generally constrained by both social and physical mores.
In nature these are called Murmurations – where you see a flock of birds or a school of fish all acting in concert with one another, even though any one of them could choose a different path.
Safety in numbers.
In the stock market many fund managers and individual investors will simply align themselves with the crowd.
It’s a lot safer than going it alone and risking shame and a loss of client funds by being a contrarian.
And for fund managers there is a real career risk of missing a rally and having to face angry bosses and clients about the lack of performance when the market is rising.
It’s safer and much easier for them to align with the crowd.
That way, you get to enjoy the rise, and if the market goes pear-shaped, then you’re not to blame since everyone else lost too.
This is exactly what happened in the global financial crisis (GFC).
A contrarian advisor or fund manager may look silly for what can be an extended period when they’re sitting in cash and the market is steadily climbing.
As an individual you have a tremendous advantage – you don’t have to benchmark yourself against 12-month returns, but simply look for wonderful opportunities to make money (and, importantly, not lose money).
The Great Humiliator
It can be difficult to sit by and watch everyone else boast about their returns in an industry that’s unforgiving in its ability to humiliate you.
Ken Fisher, a billionaire fund manager in the US calls the stock market The Great Humiliator.
Just when you think you have it sussed, the market delivers a crushing blow to your ego and your portfolio.
There’s an old saying in markets: there are old traders and there are bold traders, but there are no old, bold traders.
This is because experience can teach those who have not witnessed a significant market decline a painful lesson.
Remember many market bulls and commentators have their own interests at heart when they assure you that a high stock market and valuation isn’t a problem.
In addition to this, remember many of today’s hotshot managers have not lived through a recession or a serious sustained market decline.
In fact, while the GFC may feel like a distant memory – even to those of us who actually experienced it – it’s simply impossible to explain to a young investor the power of a lesson dispensed by The Great Humiliator.
Devil take the hindmost
Groupthink is a powerful, predominantly silent influence in our thinking, and more importantly our decision making.
That’s because we seldom act alone without any influence from others.
Ignoring others is hard since we are social animals, designed to live in packs.
So naturally we tend to check to see what others are doing.
There are several excellent reads available to give you a history of economic madness and the severe lack of wisdom of crowds.
Charles Mackay wrote Extraordinary Popular Delusions and the Madness of Crowds detailing some of the bubbles and what they looked like.
Edward Chancellor’s Devil Take The Hindmost is also an excellent source, as is Charles Kindleberger’s Manias, Panics, and Crashes.
All of these books will give you a splendid view of history and force you to understand that markets cycle, and that there’s little to be gained from simply following the crowd.
Superior investors such as Warren Buffett, Howard Marks, and George Soros have seen it all before, and their out-performance comes from their experience and ability to ignore the crowd and await the inevitable crunch.
And then they put their previous build-up of cash to more profitable use.
Work out your own strategy and look after your own interests first.
Don’t succumb to the general madness or apparent wisdom of the crowd by overstaying your welcome.
Low Rates, High Returns. 