How do investment crowds get started?

"How do investment crowds get started? There is no single right answer to this question. But I think it is accurate to say that most investment crowds find their genesis in the deaths of other investment crowds. I like to use a very apt cosmological metaphor to help understand this process. Investment crowds are the stars of the financial universe. The stars in the Milky Way and in the much larger cosmos have limited lifetimes, which typically end in a massive explosion called a supernova. But new stars are being born (i.e., starting their own process of nuclear fusion) all the time. What is the source of the material that is the stuff of a new star? Well, it is just the cosmic debris left by the explosions of old stars!

In much the same way, investment crowds burn brightly in the financial universe and are responsible for much of the observed price fluctuation. But they have finite lifetimes (a few months to a few years). The inevitable disintegration of any investment crowd causes a big run-up or drop in prices and lots of commotion and confusion in the marketplace. But the debris associated with the disintegration of a crowd is the stuff from which the next crowd forms. The change in price associated with the disintegration of an investment crowd is powerful advertising. It attracts the attention of investors, especially of those whose portfolios have been directly affected by the rise or fall in asset value."

How do investment crowds get started?

So many people can’t be wrong!

"Suppose we look closely at the behavior of investment crowds. They share one important characteristic: The members of every investment crowd are certain that the crowd’s size is evidence of the correctness of the crowd’s beliefs. So many people can’t be wrong! An investor outside the crowd is impressed not just by the crowd’s investment success but by the unanimity of its beliefs and expectations. Experience reinforced by an instinctive belief in collective wisdom then causes him to put aside his skepticism. He believes the crowd’s members must collectively know more than he does. In this way the crowd gains one more member."

So many people can’t be wrong!

A kind of social outcast in the world of investments

"I have argued that every person is born with an instinct to join social groups and cultivate social bonds with other individuals. Such instincts and social skills endow individuals with an evolutionary advantage. For this reason one expects and observes that people are far more comfortable accepting the conventional wisdom of their social groups and acting in accord with such conventions. This is true of investment crowds no less than of groups that form the larger society in which we all live. Yet a contrarian trader must place himself apart from investment crowds. By choice he becomes a kind of social outcast in the world of investments, the very world to which he has chosen to devote so much time, energy, and money. Few people can comfortably live with this sort of emotional dissonance. And this internal conflict is always felt most acutely when the financial stakes are highest, when the groupthink phenomenon associated with investment crowds is most intense."

A kind of social outcast in the world of investments

Invest in an opposite theme

"Why is it important to understand investment crowds? I have argued that large investment crowds are associated with significant market mistakes, situations in which the price of a stock, bond, or commodity is forced too high or too low relative to its fair value. If this is true, then a speculator can potentially earn above-average returns by exploiting this connection. One need only watch for the emergence of an investment crowd. As the crowd grows, it makes sense to invest in harmony with the crowd’s investment theme. But eventually the crowd grows so large that it forces the market price well past fair value. At this point the investor needs to either step aside from the crowd’s theme investment or even invest in an opposite theme."

Invest in an opposite theme

Social beacon lighting the night of investment uncertainty

"Against these costs must be laid the benefits of crowd membership. As I have said, social approval and prestige are the principal benefits. But one must keep in mind that investment crowds develop precisely because the group’s early joiners and innovators achieved very much above-average investment returns. These above-average returns act as a kind of social beacon lighting the night of investment uncertainty. Every crowd member is attracted by this beacon and motivated superficially by the prospect of duplicating this above-average investment performance."

Social beacon lighting the night of investment uncertainty

The primary cost of group membership manifests itself only near the end of a crowd’s life cycle

"For investment crowds, the primary cost of group membership manifests itself only near the end of a crowd’s life cycle. Once the crowd’s investment theme has driven market prices too high or too low, the inevitable return of the asset price to fair value causes the crowd’s late joiners to incur substantial investment losses. And it has been my observation that the majority of members of any investment crowd join only after the asset is priced above fair value (for a bullish investment theme) or below fair value (for a bearish one). It is important to remember that this sort of cost is unique to investment crowds and is not generally associated with membership in any other type of social group. For this reason it is not likely to be anticipated by people who have little experience as members of investment crowds."

The primary cost of group membership manifests itself only near the end of a crowd’s life cycle

Departure from fair value

"It is at this juncture that the formation of an investment crowd causes the market to begin its departure from fair value. New members of the crowd accept the investment theme as proven to be correct because of the big change in market price they have observed. They no longer attempt independent assessments of the relationship of price to fair value and instead accept the onward and upward assertion of fellow crowd members at face value. This willing suspension of independent thought by crowd members is the explanation for the market mistake associated with the crowd. As the crowd’s size grows, its collective market position forces the market price much higher than any reasonable estimate of fair value. The resulting bubble may well keep the market price too high for a sustained period of time if the group’s social bonds are strong and continually reinforced. But eventually all such bubbles must deflate as the underlying forces of economic competition assert themselves and drive the profitability of the associated businesses down to normal levels."

Departure from fair value