The Madness of Crowds

Source: Investopaedia (edited)

Charles Mackay wrote a book entitled "Extraordinary Popular Delusions and the Madness of Crowds".

It tells the story of several market bubbles, starting from the tulip bubble in 17th-century Holland.

All the bubbles have a similar story: an bull market in some commodity, currency or equity leads the general public to believe the trend cannot end. The optimism leads the public to overextend itself in acquiring the object of the mania. Lenders fall over each other to feed the fire.

Eventually, fear arises as investors start to think that the market is not as strong as they assumed. Inevitably, the market collapses, as that fear turns to panic selling, creating a vicious spiral that brings the market to a point lower than it was before the mania started. After that, it will take many years to recover.

The key to this phenomena lies in the nature of the crowd: the way in which a collection of usually calm, rational individuals can be overwhelmed by emotion when it appears their peers are behaving in a certain universal manner. The fear of missing an opportunity for profits is a more enduring motivator than the fear of losing one's life savings. At its fundamental level, this fear of being left out drives the overwhelming power of the crowd.

Another motivating force is our tendency to look for leadership, based on the crowd's opinion (as we think that the majority must be right) or a few key individuals who seem to be driving the crowd's behavior by virtue of their uncanny ability to predict the future.

In times of uncertainty, we look to strong leaders to guide our behavior and provide examples to follow. The market guru is an example of someone who stand as all-knowing leader of the crowd. The façade is the first to crumble when the tides of mania eventually turn.