The Madness of Crowds

March 28, 2011

Markets are sometimes very smart and perceptive, and this particular market acts “well”—an expression that is often and reasonably mocked as naive. Does this market know something we don’t? Maybe. I’m very respectful of the collective wisdom of crowds and a stock market is a crowd of investors. Please bear in mind that I am talking about crowds—not mobs. A crowd becomes a mob when it morphs in a disorderly fashion into greed, violence, and vulgarity and succumbs to emotional contagion. The etymology of mob is from the Latin: mobile vulgus. It is not crowds, but mobs, greed, and excessive liquidity that create bubbles.

Present-day equity markets in the face of earthquakes, revolutions, wars, and governments that fiddle while Rome burns continue to lurch ahead and are now generally only a couple of percentage points below their mid-October recovery highs. A great many people are angry, frustrated, and scratching their heads as to why, and there’s still a lot of money on the sidelines. The ISI hedge fund index is down from 55 to 51, and the American public continues to redeem both U.S. and emerging market mutual funds.

The financial intelligentsia is very disdainful about the intuition of markets. Much has been disparagingly written about the insanity of markets. The great classic is Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds (Broadway, 1995), which is religiously stacked in every professional investor’s bookcase. ...

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