The Madness of Crowds

In the last two secdons, we witnessed the bizarre behavior of large groups of normally sane people in a financial mania. Speculative fever or mania characterizes various periods in various countries where the prevailing investor belief pushes the price of stocks or commodities or land far above traditional standards of value. The prices stay up for weeks, for months, sometimes for years, which reinforces investor confidence and sends prices higher still.

To those caught up in the situation, it can be a heady experience. The everyday rules of the game are discarded. Profits equal to years of hard work are made in days; dreams of a lifetime are realized in months. The climb in prices becomes the obsessive topic of conversation, and dramatic stories circulate, usually embellished with each telling, of the fortunes made by individuals who got in early. In every case, the experts are sucked in, condoning the price rises and predicting higher levels. Those still on the sidelines seem to be wasting a golden opportunity, and more and more people are drawn into the boiling cauldron. It is like discovering a lottery where odds have veered suddenly and dramatically in the players favor. When investors see that the wildest gambles are rewarded with success, the voices of reason and moderation are drowned in the roar. The great bubble of hope, uru-eason, confidence, and greed floats upward. Of course, all bubbles, real or figurative, come to the same end.

These observations are anything but new. In 1852, Charles Mackay wrote his classic Extraordinary Popular Delusions and the Madness of Cwwds. Mackay described the strange behavior of people swept away by popular ideas. To the uninvolved, these ideas appear bizarre, as they do to most of the participants afterwards. The work details a number of delusions, ranging from the evacuation of London in 1524, because of the prediction of its fortune tellers that the Thames, that most docile

The people who were buying commercial real estate were not rubes. They were loan officers and other razor-sharp professionals worldwide, many of whom had devoted their entire careers to evaluating properties. These experts made bad loans that nearly wiped out the U.S. savings and loan industry, pushed the banking and insurance industries to the brink, and launched the worst panic on the stocks of financial companies since the Great Depression. Internationally, the damage was comparable.

Once again, image had leveled investors the world over.

Some Common Features of Manias

We have now considered a number of manias, two recent, the other hundreds of years earlier. All had nearly identical characteristics. Dozens of others, from tulipmania in the Holland of the 1630s to the Mississippi Bubble in the France of 1720 to the Florida Land Bubble in the late 1920s, had nearly identical characteristics.

of rivers, would suddenly rise from its banks and sweep away the city, to the preoccupation of science in the Middle Ages with alchemy, to graphic descriptions of bizarre financial bubbles. Crowd behavior in the marketplace was every bit as strange to Mackay as any other mania he documented.

The book has been widely read on Wall Street since the turn of the century. Mackay foreshadowed by 150 years the study of the intricate and varying psychology of the marketplace. Bernard Baruch, an outstanding investor of the earlier part of the century, wrote the preface for the reissue of Mackays book, and was fond of giving copies to young people coming into the industry to help them understand the powerful psychological forces often unleashed in markets.

Mackay was expert at capturing the mood of the crowd. He relates how speculators, driven to frenzy by the rise in price of the South Sea Company shares in 1720, searched London for the next big winner, just as investors look for the next Intel or Microsoft today. Ideas that were far-fetched, if not in la-la land, attracted scores of buyers. Companies were sold to extract oil from radishes, make gold out of sea water, and even to bring up hellfire-presumably an early form of central heating.

At its height, the South Sea Company had a market value of 500 million pounds, roughly five times the cash in all of Europe. In retrospect, the enormous valuation placed on the company seems absurd, yet the crowd believed it was only the beginning. The end came, as it came to 275 years later. In days the wealth of thousands was swept away.

As Mackay observes:

We find that whole communities suddenly fix their minds upon one subject, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion and run after it.... Sober nations have all at once become desperate gamblers, and risked almost their existence upon the tum of a piece of paper. .. . Men, it has been well said, think in herds ... they go mad in herds, while they only recover their senses slowly and one by one."*

First, prices were talcen far in excess of real value. Real estate was wildly overvalued in the 1980s, and had no substance at all. Second, the crowd bought the concept by the hundreds of thousands in the case of real estate in the 1980s and by the millions in the Russian case. Third, reality (or rationality) excused itself almost completely. Prices rose an astounding amount: 6,500% for , within months. Is it madness to buy a stock that traded at $1,000 a few months back for $20,0 today, when the underlying value has not changed in the least? The answer has always been yes. Still, people have done so repeatedly in the past and will do so again.

How can so many people be part of such a colossal folly? For further perspective lets turn to another early student of crowd psychology.

The Characteristics ofa Crowd

Another early observer of the strange behavior of crowds was a Frenchman named Gustave Le Bon, who in 1895 wrote The Crowd. Like Charles Mackays work, it is a classic. Le Bons work contains some remarkable insights into the behavior of crowds, many of which apply to the lemming-like actions of investors.

One of the most striking features of the crowd to Le Bon was its difficulty in separating the imagined from the real.

A crowd thinks in images, and die image itself calls up a series of other images, having no logical connection with the first... A crowd scarcely distinguishes between the subjective and the objective. It accepts as real the images invoked in its mind, though diey most often have only a very distant relation with the observed facts.... Crowds being only capable of thinking in images are only to be impressed by images."

At times, as Le Bon saw, the image evokes cruel behavior; the belief in "one true faith" sent millions to their deaths over the centuries, and the "isms" of this century have taken tens of millions of lives. At other times, the image can inspire heroism, as with the crowd that stood against the Chinese tanks in Tiananmen Square, or the Russians who lined up almost weaponless to protect the parhament building against the well-armed KGB attack in 1991. With die benefit of hindsight, the image may become droll, as when London was abandoned to the Thames. But to capture the crowd, the image must always be simple. Le Bon believed the individual regresses in a crowd and "descends several rungs in the ladder of civilization. Isolated, he may be a cultivated