The Timeless Nature of the Herd Mentality

Gustave Le Bon was a French psychologist who wrote The Crowd: A Study of the Popular Mind all the way back in 1895. The passage sums up his findings pretty well (emphasis mine):

The most striking peculiarity presented by a psychological crowd is the following: Whoever be the individuals that compose it, however like or unlike be their mode of life, their occupations, their character, or their intelligence, the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind that makes them feel, think and act in a manner quite different from that in which each individual of them would feel, think and act were he in a state of isolation. There are certain feelings that do not come into being, or do not transform themselves into acts, except in the case of individuals forming a crowd.

The herd mentality is something that I find facsinating when it comes to the market. Sometimes the crowd is right. Other times people collectively lose their minds when following the actions of others. Investors often get caught up in this type of mindset during times of euphoria or panic because there’s a safety in numbers. People look around to see what everyone else is doing and allow the crowd to guide their actions because it’s a comforting feeling to do what everyone else does.

Another great take on the herd mentality comes from one of my favorite books on financial market history, Devil Take the Hindmost (again, emphasis mine):

The intellectual inferiority of the crowd is a sign that people are filtering and manipulating new information to make it accord with their existing beliefs. Psychologists call this behavior “cognitive dissonance.” Dissonant information, which contradicts the collective fantasy, is uncomfortable and people seek to avoid it. They may do this either by shooting the messenger or by proselytizing and seeking fresh converts to their fold. In his Theory of Cognitive Dissonance, Leon Festinger argued that people will tolerate increasing degrees of dissonance if they are motivated by a sufficiently enticing reward. In financial markets one might say they are prepared to ignore bad news because they still hunger after the immediate profits of speculation. A description of the speculators in William Fowler’s circle during the 1860s provides and illustration of this behavior. They were engaged, wrote Fowler, “in bolstering each other up, not for money, for we thought ourselves impregnable in that respect, but by argument in favor of another rise. We knew we were wrong, but tried to convince ourselves that we were right.

What I find amazing about these passages from the 1800s is how relavant they remain in today’s day and age. Although market structure and technological innovation mean today’s markets don’t come close to resembling those of the past, human nature is always the constant. It seems these gentlemen were early adoptors of behavioral economics.

People are quick to blame every market move on the Fed these days. It’s as if they think bubbles didn’t exist in the pre-Fed era. Maybe the Fed changes the timing and the magnitude of these things, but it would be silly to assume that human behavior wouldn’t cause the pendulum to swing too far in both directions even if the Fed didn’t exist (do yourself a favor and see what the economy was like before Fed intervention).

Herd behavior comes about because of the fear of missing out, the fear of being in, ignorance, greed and loss aversion. The technical reason is different ever time something gets too far our of whack in the markets, but the real reason never changes — we’re human.

Sources:
The Crowd: A Study of the Popular Mind
Devil Take The Hindmost

Further Reading:
The Value of I Don’t Know

 

 

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  2. Mark Massey commented on Apr 27

    a couple of keys to avoid crowd think: while not being egotistical, it pays to understand what you are doing and have a reasonable level of confidence in your thinking; and always be a critical thinker…ALWAYS. I do not care if it is Warren Buffett giving me direct personal investment advice. I would pick it apart before acting on it. Never accept anything on its face.

    • Ben commented on Apr 27

      Yup and I think consistency of process is vitally important as well. it’s hard to be disciplined and consistent when everyone else is not.

      • Mark Massey commented on Apr 27

        The discipline and consistency naturally accompanies critical thinking…at least for me that is the way it works. It could be said it is all sort of circular. Do knowledge of equity investing and confidence in your investment process beget critical thinking and discipline in your process, or does the latter create the former, or does it all come in one fortunate package, or what?

        • Brian Young commented on Apr 27

          Like most things, I think that cause -> effect will run both ways in this case. A knowledge of investing and confidence in your process would beget the discipline to utilize that process. Discipline and a tendency towards critical thinking developed in other avenues of life would beget a requirement to develop investment knowledge and a process prior to participating. 6 up and half a dozen down, so to speak.

          • Mark Massey commented on Apr 27

            Makes sense to me. Prior careers in banking, law, and as a retail owner/operator did much to prepare me for a career in investment advising/management.

          • Ben commented on Apr 27

            Well said. It all comes down to self-awareness in my opinion.

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