The wisdom and madness of crowds

In an age where social media can shape opinion in an unprecedented way, it’s increasingly important for investors to consider the psychological behaviour of crowds.

| 7 min read

Collective human knowledge can be a remarkable force. Sometimes it’s referred to as the “wisdom of the crowd”, the concept that the many are wiser than the few.

In 1907, statistician Francis Galton was surprised by this phenomenon during a visit to a Plymouth farmer’s fair where, he observed, attendees were invited to estimate the weight of an ox to win a prize. On studying the data Galton found that none of the roughly 800 guesses were exactly right, but was astonished to find the average of them was remarkably close. Many experiments and studies along similar lines have been conducted since. They frequently bestow the crowd with a superhuman quality, the ability to make better predictions than the experts.

From a mathematical perspective, it makes sense. Taking the average irons out the significant outliers – guesses that are way over or way under the mark – and converges on a pretty accurate answer given a large enough sample. Anyone who has watched the game show Who Wants to Be a Millionaire will appreciate that the ‘Ask the Audience’ option is often a more valuable option than the ‘Phone a Friend’ unless that friend happens to be a genuine subject matter expert.

In the stock market, the price of a share is, similarly, a group decision, an average of all the estimates of market participants. It is essentially a voting machine for share prices.

The crowd can be biased

Sometimes, though, the vox populi isn’t very perceptive. The ‘average’ judgment can be inaccurate, or a group can converge on a wrong solution. Often this is due to outside influence. In a ‘guess the weight of an ox’ or ‘number of sweets in a jar’ competition, for instance, a participant could be influenced by knowing the guesses of other entrants. Other people’s judgments and arguments can sway opinion, so for the ‘wisdom of the crowd’ effect to work well, decisions need to be independent of one another.

It’s also been observed that the wisest crowds are the most diverse. Diversity promotes independent thinking and avoids an ‘echo chamber’. People start to doubt their own views when the weight of opinion is against them, there is a tendency to drift with the ‘herd’. As such, there is a strong argument for diversity within the business world.

There are also a number of lessons for investors, especially in an age where social media can shape opinion in an unprecedented way. Social media networks can generate considerable ‘confirmation bias’, a psychological behaviour where individuals disregard information that contradicts their beliefs. That’s potentially dangerous for investors. A dogmatic opinion of an economic trend or asset can lead to an imbalanced view, and to downplaying risks or missing opportunities.

For more impressionable or novice investors there is even greater danger as it is hard to work out who to believe. Some ‘finfluencers’ make sensational claims or have extreme views to win followers, which is ultimately what they are most interested in.

When the crowd goes mad

There are also instances where the wisdom of the crowd is way off the mark. The crowd can just go crazy. Often this is when, rather than making individual decisions, activity is centred around ‘herding’. People do something because others are doing it, for instance piling into assets because they see others making money rather than independently considering fundamental factors such as valuation.

Throughout history, there have been many fads and manias that captured imaginations and sucked in money with a good story but shaky foundations. Tulipmania in 17th century Amsterdam, the 1711 South Sea Bubble and late nineties dot-com mania were all financial bubbles that tempted investors into doing the wrong thing. To run with the herd off the metaphorical cliff edge.

Episodes like these are easy to identify in retrospect, and often contain comical folly, but when they are happening it’s easy to get sucked in no matter who you are. Sir Isaac Newton was so affected by the South Sea Bubble that he is claimed to have said that he ‘could calculate the motions of the heavenly bodies, but not the madness of people’. It’s perhaps less mysterious for students of human psychology where the fear of missing an opportunity for profit has been shown to be a hugely powerful motivator.

In modern parlance, this is 'FOMO', or the Fear of Missing Out. As Jeremy Grantham succinctly put it, ‘There is nothing more supremely irritating than watching your neighbours get rich.' When the force of emotion takes over when people fear being left behind as friends, relatives and colleagues seem to be making a killing, the wisdom of the crowd is drowned out. It is overwhelmed by the power of herd behaviour.

Charles Mackay, who wrote extensively on manias in Extraordinary Popular Delusions and the Madness of Crowds in 1841 explained, "Men, it has been well said, think in herds; they also go mad in herds, while they only recover their senses more slowly, and one by one." This neatly describes the impulsive, copycat nature of FOMO and the subsequent slower, more calculated reflections that come over time. Yet some bubbles end in a more spectacular crash as investors panic and the herd takes flight.

The lessons from crowd behaviour

What does all this tell us about more recent market action? Crowd psychology is always at play to some extent in dictating market swings, and a prime example can be seen during the global pandemic. As panic increased, stock market volatility followed. Fear then gave way to greed as markets recovered and ignited the interest of many inexperienced, novice investors. ‘Meme stocks’ and crypto assets were at the centre of the speculation spurred on by the excited sharing of ideas on Reddit, Twitter or TikTok.

During 2020, there were few penalties for taking very high levels of risk, but for the past year or so this activity has subsided. Markets anticipated higher interest rates from the world’s central banks and a winding back of the quantitative easing that flooded money into the system during the pandemic. This raises the cost of borrowing and ‘tightens’ financial conditions, a far less conducive environment for impulsive speculators. This is perhaps something that helps explains the recent precipitous declines in crypto ‘assets’, most spectacularly the prices of Luna and TerraUSD in recent weeks.

More broadly, acknowledging the psychology of crowds is important in stock market investing. As well as representing the sum of hopes and fears, financial markets are dictated by the equations of wisdom and madness too. When people are overtaken by greed or fear, overreactions can take place that distorts prices. Asset bubbles can inflate well beyond reason or fundamentals, or, in the depths of fear, panic can drive prices far lower than justified. This has been a constant feature of stock market history, and there is no reason to think it won’t be going forward – it’s a product of the collective human mind.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

The wisdom and madness of crowds

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