Crowd Psychology and Crises

 

Edson Gould felt his most important discovery was “the action of the stock market is nothing neither more nor less a manifestation of mass crowd psychology in action.”

Gould made his discovery in Gustave Le Bon’s 1895 book, The Crowd: A Study of the Popular Mind Le Bon (1841-1931), a French social psychologist, sociologist and physicist, also wrote about anthropology and archaeology. His ideas influenced many people including, Hitler. A few of his ideas were proven false, but they are still taught today.     Le Bon wrote about psychology that created financial havoc over the centuries.

Other writers wrote about the financial havoc that psychology helped to cause:

 

• In 1841, John Mackay (1814-1889), a Scottish journalist and accomplished teller of stories, wrote Extraordinary Popular Delusions and the Madness of Crowds. He wrote about early bubbles or financial manias like the South Sea Company bubble of 1711-1720, the Mississippi Company bubble of 1719-1720 and the Dutch tulip mania of the early 17^th century.

 

• In 1978, economic historian Charles Poor Kindleberger, II (1910-2003), and Robert Z. Aliber wrote Manias, Panics and Crashes-A History of Financial Crises. This tome describes the history of financial money and credit mismanagement and lessons learned.

 

• In 1933, Robert L. Smitley (1881-1964), a bookstore owner on Wall Street, became an expert on investor psychology, wrote Popular Financial Delusions. Robert explored investors’ common delusions and misconceptions.

One of Smitley lectures was, “An abstract of the Known Histories of Polybius Written about 170 B.C.” It compared investors’ abstractions with modern conditions and pointed out fundamentals to show how little fundamentals have changed in the last 2100 years.

 

• In 1902, Financial Crises and Periods of Industrial and Commercial Depression, written by Theodore E. Burton (1851-1929), U.S. Senator from Ohio and co-sponsor of the Sherman Anti-Trust Act. The book was written before the Federal Reserve existed and events of the 1930s.

This issue is a snapshot of investment psychology, crises, manias and delusions. We can see that there is nothing new when human nature is involved and it would be wise to learn from history rather than think new is always better. If we choose to do so, we can profit from history’s mistakes.

 

Causes of Crises

 

Let’s look at the most strongly advocated theories, and those that have the largest degrees of truth:

 

1. Lack of confidence
2. The abuse or undue extension of credit (by excessive bank credits or by inflated currency issues
3. The readjustment of conditions resulting from inevitable changes in values or prices
4. A general fall in prices
5. General changes in prices resulting from changes in the monetary unit
6. Contraction of the circulating medium or insufficient volume on money
7. Over-production or under-consumption
8. Psychological tendencies – the mental and moral disposition of mankind.

 

“Some of the above influences may create a derangement, which may directly cause a panic or crash. Indirectly it may cause a more serious and permanent condition known as a depression (aka recession).

Depression/recession may be greatly intensified by some or all of these influences. The central fact in all depressions/recessions, as well as in those crises followed by depressions, is the condition of capital. These disturbances are due to derangements in condition, which can take the form of waste (or excessive loss of capital or its absorption), to an exceptional degree, in enterprise not immediately remunerative. In some form waste, excessive loss, or absorption, is the real cause. Others may say that crises and depressions/recessions are due to misdirection of productive energy.”

Excerpts from Popular Financial Delusions, by Robert L. Smitley

 

• “The destiny of nations is governed by psychological Influences and economic necessities.”

 

• “…we cannot go back to a currency era without massive upheavals. The cause of the great boom was credit expansion to an abnormal degree-the same cause as that for all booms under a credit system.”

 

• “Possibly the easiest act for any human being is to spend money, which does not belong to him.” The only easier activity is lending money that is not yours and earning a yield on either the profit or loss. Almost anyone will risk funds in an enterprise when the funds are not his own.”

 

• “The great universities find that when their outstanding economic teachers are called into the business arena, the result is pitiful not only for business but for the teachers…. The way (these) $3,500 boys accepted $30,000 ($1 then is worth $20 today) a year jobs with the Investment trusts back in 1928 and 1929 and found themselves earnings a pittance as hack writers in 1933 by writing daily columns forecasting the stock prices and estimating the wheat crop”

 

The Delusion of Government

• “The Government should do something about it.

Relief for the farmers is imperative. The Government must guarantee bank deposits. The Government should issue more money. All of these and hundreds more of the same kind were said during a time of deflation. The ridiculousness and inanity of the remarks indicated ignorance beyond belief. There could be no government without people and the economic success of any people depends upon a combination of individual cooperation plus leadership. Therefore, every step taken by the government meant a tax upon the people. Nowhere has this been less understood than in the United States. It was only in March 1933 that a delusion of the government as a separate entity from the people as a whole reached a few of the minds in the mob. The most common aspect of the delusion had to do with money. It seemed the average person believed that all the Government had to do was “make” money. They never seemed to get the idea through their ‘thick skulls’ that the finance of government comes under the same economic imperatives as that of the individual…

If government deludes itself as a separate entity from the individual, the price to be paid for this will be far greater than the pleasure of our belief in it.”

Excerpts from Popular Financial Delusions, by Robert L. Smitley

 

• “The destiny of nations is governed by psychological Influences and economic necessities.”

 

• “…we cannot go back to a currency era without massive upheavals. The cause of the great boom was credit expansion to an abnormal degree-the same cause as that for all booms under a credit system.”

 

• “Possibly the easiest act for any human being is to spend money, which does not belong to him.” The only easier activity is lending money that is not yours and earning a yield on either the profit or loss. Almost anyone will risk funds in an enterprise when the funds are not his own.”

 

• “The great universities find that when their outstanding economic teachers are called into the business arena, the result is pitiful not only for business but for the teachers…. The way (these) $3,500 boys accepted $30,000 ($1 then is worth $20 today) a year jobs with the Investment trusts back in 1928 and 1929 and found themselves earnings a pittance as hack writers in 1933 by writing daily columns forecasting the stock prices and estimating the wheat crop”

 

The Delusion of Government

• “The Government should do something about it.

Relief for the farmers is imperative. The Government must guarantee bank deposits. The Government should issue more money. All of these and hundreds more of the same kind were said during a time of deflation. The ridiculousness and inanity of the remarks indicated ignorance beyond belief. There could be no government without people and the economic success of any people depends upon a combination of individual cooperation plus leadership. Therefore, every step taken by the government meant a tax upon the people. Nowhere has this been less understood than in the United States. It was only in March 1933 that a delusion of the government as a separate entity from the people as a whole reached a few of the minds in the mob. The most common aspect of the delusion had to do with money. It seemed the average person believed that all the Government had to do was “make” money. They never seemed to get the idea through their ‘thick skulls’ that the finance of government comes under the same economic imperatives as that of the individual…

If government deludes itself as a separate entity from the individual, the price to be paid for this will be far greater than the pleasure of our belief in it.”

The Crowd by Gustave Le Bon

Characteristics of crowd psychology: Impulsive-ness, irritability, incapacity to reason, the absence of judgment of the critical spirit and exaggeration of sentiments (crowds do not admit doubts or uncertainty). Crowds are credulous and readily influenced by suggestion. The morality of crowds may be much lower or much higher than that of the individuals composing it.

 

Three processes create a crowd:

Anonymity – Provides rational individuals a feeling of invincibility and loss of personal responsibility. An individual becomes primitive, unreasoning, and emotional which, allows him to yield to instincts.

Contagion – To the spread in the crowd of particular behaviors, where individual sacrifice their personal interest for the collective interest.  Suggestibility – The mechanism through which the contagion is achieved. When the crowd becomes homogeneous and malleable to suggestions from its strongest members-the leaders, the leaders are usually men of action rather than words. They are not gifted with keen foresight and are agitators or hypnotizers of individuals.

 

Impact of civilizing elites and barbarian crowds upon civilization: So far, civilizations have only been created and directed by a small intellectual aristocracy, never by crowds. Crowds are only powerful for destruction. Their rule is always tantamount to a barbarian phase. A civilization involves fixed rules, discipline, a passing from the instinctive to the rational state, forethought for the future, an elevated degree of culture—all conditions that crowds. When the structure of a civilization is rotten, the masses always bring about its downfall.

 

Trading for a Living – Dr. Alexander Elder noted a number of points from Le Bon’s book, Mackay’s book and psychology:

 

• You may base your trades on fundamental and technical analysis but psychology is the key to success.
• Mackay’s book described many of the manias that have occurred in history. Human nature changes slowly and today new mass manias, including guru manias, continue to sweep the markets.

 

INFO FOR BOX VVV

“The public wants gurus, and new gurus will come. As an intelligent trader, you must realize that in the end, no guru is going to make you rich. You have to work on that yourself”                   

END OF BOX INFO

There are three types of gurus in the financial markets today: market cycle (timing the markets) gurus, magic method (new analytic or trading method) gurus and dead (R. N. Elliot or W. D. Gann) gurus.

 

 On mass psychology:

Everybody has a chance to buy and to sell. Each price is a momentary consensus of value of all market participants, expressed in action. Price is a psychological event–a momentary balance of opinion between bulls and bears. Prices are created by masses of traders—buyers and sellers, and undecideds. The patterns of prices and volume reflect the mass psychology of the markets. There is a crowd of traders behind every pattern in the chart book.

 

INFO FOR BOX VVV

Technical analysis is applied social psychology. It aims to recognize trends and changes in crowd behavior in order to make intelligent trading decisions

END OF BOX INFO

 

The market is a huge crowd of people. Each person tries to take money away from the other by outsmarting them. The market is a uniquely harsh environment because everyone is against you and you are against him or her.

 

Today, a trader who reads The Crowd can see his reflection in a century-old mirror. Le Bon wrote,

• When individuals, however like or unlike be their mode of life, occupations, character, or intelligence, have been transformed into a crowd, they are in possession of a collective mind, which makes them feel, think, and act in a manner quite different from that in which each individual would feel, think, and act were he in a state of isolation.

 

• A soldier who trusts his leader will literally follow him to his death. A trader who believes he is following a trend (price is the leader of a market crowd) may hold a losing position until his equity is wiped out.”

 

• Human nature prepares you to give up your independence under stress. When you put in a trade, you feel the desire to imitate others and overlook objective trading signals. This is why you need to develop and follow trading systems and money management rules. They represent your rational individual decisions, made before you enter a trade and become a crowd member.”

 

 

Thoughts from Charles Poor Kindleberger

 

The World in Depression, 1929-1939 was so wide, so deep, and so long because Britain had an inability and America was not willing to assume responsibility for stabilizing the international economic system.

They could have done so by implementing five functions:

1. Maintaining a relatively open market for distress goods
2. providing countercyclical, or at least stable, long term lending
3. Policing a relatively stable system of exchange rates
4. Ensuring the coordination of macroeconomic policies
5. Acting as a lender of last resort by discounting or otherwise providing liquidity in financial crisis

 

The monetary history of the last 400 years has been replete with financial crises. There was a pattern of increased investor optimism as economies expanded. There was an increased rate of credit growth and accelerated economic growth as well as an increasing number of individuals who began to invest for short-term capital gains rather than for the returns associated with the productivity of the assets they were acquiring. The increase in the supply of credit and buoyant economic outlook led to economic booms as investment spending increased in response to a more optimistic outlook and greater availability of credit as household spending increased as personal wealth surged.

 

Economic responsibility and military strength are costs of peacekeeping. Free riders are perhaps more noticeable in the type of economy, in which a number of rules in trade, capital movements, payments and the like have been evolved and accepted as legitimate.

 

Free ridership means that disproportionate costs must be assumed by responsible nations, which must occasionally take care of international interests that fall short of immediate goal. The requirement is for active, not merely passive responsibility of the German-Japanese variety. With free riders and the likely emergency of thrusting newcomers’ passivity is a recipe for disarray.

 

The danger for world stability is the weakness of the dollar, the loss of dedication of the United States to the international system’s interest, and the absence of candidates to fill the vacuum.

Three Types of Bubbles

 Speculative Bubbles:

These are self-fulfilling prophecies. Prices rise rapidly and then fall sharply to a presumed fundamental level. The price keeps rising due to expectations of increased demand. An outside shock comes, breaks expectations and speculative demand evaporates causing prices to fall quickly.

 

No General Panic:

Prices rise, stay at a peak for a while, and then fall as rapidly as they rose. It is not a crash but prices rise above fundamental values and fall again.

 

A Panic and Crash:

Prices rise to a peak and then gradually decline. We then see a panic and crash.

Most investors follow this type of bubble. Some insiders get out at the peak and others hang on during the financial crisis until the panic and crash. Examples of this type of bubble are the Mississippi bubble of 1719, the South Seas bubble of 1720, the U.S. stock market bubbles of 1928-1929 and 1987.

 

Kindleberger, Hyman Minsky and others studied these bubbles.

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Based on Kindleberger’s ideas, Hyman Minsky created his credit cycle model. The model had five stages: displacement (investors getting excited about something like an invention war or an abrupt change in economic policy), boom, euphoria (banks and other lenders extend to ever more dubious borrowers, often creating new ways to lend), profit taking (by smart traders and insiders) and panic. It seems history has a script.

 

Kindleberger believed “markets work well on the whole,” but occasionally “will be overwhelmed and need help” from a lender of last resort. He knew the danger of inaction by such a lender and a “moral hazard.” A moral hazard is created when investors are reckless in the belief that they will be bailed out if all goes wrong. He said a lender of last resort should exist, but its presence should be doubted. A lender should always come to the rescue but leave it uncertain as to whether the rescue will arrive in time or at all, to instill caution. Pulling this off is, he noted, a “neat trick”.        The Economist July 17, 2003

 

 END OD ARTICLE