The dangerous comfort of crowds

The dangerous comfort of crowds

30 Aug 2013

The British football season is back. After a few weeks’ break, perhaps spent on surprisingly hot beaches, the fans have returned to the comforting warmth of whichever partisan crowd they belong.

The Latin for crowd is “vulgus” and the word “mob” derives from “mobile vulgus” meaning, roughly, a movable (or swayable)crowd. When waging war, nations need to mobilize their armies – effectively to persuade crowds of generally quite harmless people to unite with the intention of killing other people. Armies are notoriously intolerant of any individual considered to be breaking rank. In WWI, the British executed 306 men for “desertion”. Almost all were young men from non-commissioned ranks and their punishment was seen as exemplary in the most sinister way.

DH Lawrence, who was, awkwardly, a pacifist married to a German, wrote of the “vast mob-spirit” of the war. Those lucky enough to survive WWI were sent home to lives of economic uncertainty and a widespread fear of Bolshevism, which meant that organised labour was regarded with hostility by what we can call the ruling classes. The hindsight of history judges that the ordinary “heroes” of WW1 were treated pretty shabbily. Their experience was called being “demobbed”.

Crowds are needed to fight wars and insult referees but what else are they good for?

Political extremism and hard-line religion spring to mind. Come to think of it, these sometimes result in wars too. In all cases, the crowd induces people to behave in a way that might not seem obvious or even wise to according to rational introspection. This is an investment website and it must be obvious where I am heading but there is one general point that I would like to emphasise: crowds are comforting to belong to and can be uncomfortable (to say the least) to be excluded from.

This leads straight to what is, in my view, the saddest sentence ever written about professional investors.

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

J M Keynes (The General Theory…)

What a bleak observation of human mediocrity.

Long before Keynes (in 1841), a Scot called Charles Mackay published “Extraordinary Popular Delusions and the Madness of Crowds”, which was, as far as I know, the first attempt to explain financial bubbles.

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

In 2004, James Surowiecki published The Wisdom of Crowds which not really a refutation but a case for the collected wisdom of individuals over the opinions of acknowledged experts who tend to suffer from the mutually endorsed prejudice of a closed group. In my view, Surowiecki’s point is best illustrated by the reaction of a financial market to a piece of news. When the “expert” financial analysts (of whom I once was one) say that a company’s results are very bad, yet its shares rise in response, the news is said the have been “in the price”. The bad news was an “unknown known” understood by the crowd but not by the individuals within it.

Herd behaviour is quite different. To quote from this superb psychology and finance blog:

…It certainly seems that mimicry lies behind a lot of observable animal behaviour, from mate selection through to dietary choices. Especially in situations of uncertainty it makes perfect sense to copy what everyone else is doing. You just hope that when the fire alarm goes off the confident person everyone else is following knows where they’re going.

What psychology suggests is that sometimes these mimicry effects can set off information cascades – a kind of chain reaction where everyone copies everyone else thinking that everyone else knows what they’re doing. At this point we’re no longer doing our own rational analysis but are simply copy the nearest available role models, whether these are neighbours, internet buddies or just the bloke in the bar last night.

Information cascades have a number of interesting qualities: they can emerge quickly based on the behaviour of a few dominant individuals but they’re very fragile, because the receipt of new and conclusive information can cause people to suddenly change their minds. They’re also associated with sudden stampedes as everyone charges off in the same direction, seemingly all at once. Basically, an information cascade looks an awful lot like what happens when a herd of stockmarket investors all go mad at exactly the same time.

I think that we can all agree that none of us wants to be a herd investor, even if we enjoy watching football. A couple of nights I watched a dull game between Manchester United and Chelsea which was most notable to me for close up shots of United supporters screaming obscenities at a man (as it happens, a Chelsea player) who was just a few feet away. I imagine that if one of those supporters found himself in a room in which the only other occupant was Ashley Cole (for it was he), he would probably not point his finger in Cole’s face and shout at him. More likely he would hold his camera phone at arm’s length and try to take a picture of the two of them posing as mates.

Most likely the supporter knows this – he accepts that his behaviour in the crowd is different and probably values it for that reason. When the game is on, reality is obscured for a while.

Sadly, the herd investor does not seem to be as smart as a football supporter. Armed with such comforting phrases as “the trend is your friend” and “go with the flow”, the herd investor imagines that he will be able to break free of the pack when the time comes to do so.

Resolving not to be a herd investor is necessary but not sufficient. It makes no sense to be a contrarian for the sake of it. One cannot reject an opinion merely on the grounds that others hold it. One must rather be constantly vigilant. There is a frequently quoted line from a movie about poker (Rounders):

 “If you can’t spot the sucker in your first half hour at the table, then you are the sucker.”

One might say of investing that if you can’t see which way the herd is running, then you might be in the middle of it. Or it might not be running at all. There are always so-called “crowded” investments where the price of an asset or class of assets is driven up by its popularity. To persist with the simile, this is like a herd of cows working a field. After a while they need to be moved to pastures new.

Crowds have collective memory. Most investors today experienced or know of the tech bubble and the sub-prime property collapse. Consequently, the financial TV channels are well populated with experts warning of the next crash in something or other (this week it is emerging markets). Perhaps the doomsayers are herding and the next crash will be in experts.

Trying to be fair and serious, quantitative easing is calculated herd-like behaviour on the part of the US Fed and the Bank of England and this demonstrably caused bubble-like valuations in government bonds and flooded the former holders of those assets in liquidity. This in turn has inflated the prices of competing assets (everything looked cheaper than a 10 year bond paying 1.5%) including those in emerging markets (see above). This in turn has caused paranoia whenever the possibility of QE tapering has been suggested.

Crowds’ collective memories eventually turn into collective amnesia. One day, if QE goes on and on (as I suspect that it will), the herd will take it for granted. Until then, corrections in government bonds, as we have seen recently, seem to me to be good for us. The idea that everything is cheap relative to Treasuries is dangerous. Today’s 10 year yield of 2.75% is well up over the absurd levels of summer 2012. This may not be the bargain of the year but it deserves a seat at the table. And it may not be the sucker.

Crowds and bubbles don’t scare me.

Yet.

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