"Fervor's Flock: The Phenomena of Crowd Psychology in Finance"
“An individual in a crowd is a grain of sand amid other grains of sand, which the wind stirs up at will. "
-Gustave LeBon
Envision a stadium crowd roaring with anticipation, a political rally throbbing with collective fervor, or Wall Street traders scrambling to sell in the wake of sudden bad news.
These are all instances of crowds- those swirling masses of humanity that have long captivated philosophers and social scientists alike.
For centuries, philosophers have grappled with the essence of crowds.
As the 18th-century philosopher Jean-Jacques Rousseau observed, "We have a very imperfect knowledge of the human heart if we do not also examine it in crowds."
Crowds, in their very nature, challenge our assumptions about individual behavior.
But what about crowds makes them so intriguing and even unsettling at times?
In the anonymity and collective energy of a crowd, people can shed their inhibitions and be swept up in a wave of emotion that can be both exhilarating and frightening.
And why is an understanding of the psychology of crowds crucial to understanding financial bubbles?
The Father of Crowd Psychology
Gustave Le Bon, a pioneering French social psychologist of the 19th century, is the "father" of crowd psychology.
Le Bon believed that understanding crowd psychology was essential to comprehending not only the ebb and flow of history but also humanity's very nature.
In his seminal work, The Crowd: A Study of the Popular Mind, Le Bon argued that crowds possess a distinct mentality, one that is often ruled by "sentiments and ideas in a primitive form." Le Bon likened crowds to "primitive beings," suggesting they resemble our evolutionary ancestors more than the composed individuals we think ourselves to be.
Le Bon highlighted three characteristics of a crowd: Anonymity, Contagion, and Suggestibility.
Anonymity refers to an individual becoming primitive, unreasoning, and emotional. Even rational individuals achieve a feeling of invincibility and the loss of personal responsibility.
Contagion describes the spread of particular behaviors in the crowd.
Individuals begin to sacrifice their personal interests for the collective interest.
Suggestibility is the mechanism by which contagion is achieved.
As such, the crowd robs each member of their opinions, values, and beliefs.
Le Bon saw crowds as a double-edged sword: a force that can be manipulated for nefarious purposes or a powerful engine for social change.
Le Bon recognized the potential for heroism, generosity, and sacrifice that crowds can unleash.
He pointed to the crucial role that crowds have played in erecting the pillars of modern civilization. "In crowds," Le Bon observed, "sentiment and ideas are contagious." This contagiousness can fuel both positive and negative actions, depending on the context.
The Crowd on Wall Street
Le Bon's theories are particularly useful when examining the behavior of financial manias.
With their rapid information flow and the constant hum of emotional energy, financial markets can be fertile ground for crowd psychology to take hold.
The irony is that LeBon never mentions financial markets or manias- unlike the earlier work of Charles MacKay’s Popular Delusions and the Madness of Crowds.
Yet, history is littered with examples of financial manias that perfectly illustrate Le Bon's ideas.
The infamous tulip mania that gripped Holland in the 17th century, the South Sea Bubble of the 18th century, the roaring Twenties and the crash of 1929, the dot-com boom and bust of the late 1990s, and even the recent surge in Tesla's stock price all share a common thread: the intoxicating power of crowd mentality.
In each of these cases, a combination of factors—positive news stories, celebrity endorsements, and the fear of missing out (FOMO)—fueled a collective belief that defied fundamental economic principles.
Today, social media makes it easier than ever for crowds to form and galvanize around shared ideas.
However, the anonymity and speed of online interaction can often exacerbate the negative aspects of crowd psychology.
Misinformation can spread like wildfire, fueling outrage and division. The echo chamber effect can reinforce existing biases, making it harder to have constructive dialogue.
LeBon’s Impact Today
Le Bon's theories continue to resonate today. We see crowd psychology play out in the fervor of political rallies, the contagious enthusiasm of sporting crowds, and the dangerous anonymity that can embolden online mobs.
The irony is that crowd behavior is not taught in business schools, and the CFA program ignores it. Modern financial theory assumes it away.
After all, investors are superrational homo economicus. And their behavior falls within the parameters of a normal distribution curve.
Even cutting-edge behavioral economics focuses on individuals' cognitive biases, not on the collective behavior of individuals in a crowd.
The only time I’ve come across a discussion of crowd psychology is in The Intelligent Investor by Ben Graham – the father of value investing.
There, he describes this behavior using the metaphor of Mr. Market's mood swings.
Perhaps it’s no surprise that Warren Buffett has described the chapter as one of the two most important things he has ever read.
The bottom line?
Understanding how crowd psychology influences market behavior is more than just an intellectual curiosity.
It is a crucial investment tool that can help us navigate the complexities of our interconnected world, become more aware of our biases, and make more informed investment decisions.