It is well known that usually rational investors are sometimes prone to depart from their normal logic and follow the mass hysteria.

The reason is that investors’ behavior may change according to the dictates of crowd psychology.

The investor influenced by the crowd’s emotional stampede proceeds to make compulsive, irrational decisions. For example, buying stock at the top of a movement or selling stock at the bottom of a price movement.

Investment Choices – Rational or “Herd Instinct”

Every Investor has a conflicting two-way pull on investment decisions, resulting in two possible courses of action:

• Adhere to one’s own personal approach to investment, or
• Succumb to the lure of the crowd mentality

To understand herd instinct, it is helpful to consider the nature of crowd membership, a phenomenon first analysed by the French social psychologist, Gustave Le Bon (1841 – 1931).

Le Bon suggested that, on the one hand, each person has a self-assertive tendency, or ability to behave in a self-determined, individualistic way. On the other hand, each individual also has a willingness to belong to crowds, causing one to behave differently from the way one would otherwise behave in isolation.

Self-Organization of Hierarchical Levels

Crowds emerge as a result of the same basic laws that apply to the rest of nature, according to self-organizationof hierarchical levels. Each level has the power to organize lower levels and use them for their own purposes. For example, the hierarchical structure of human groupings would be:

Civilizations -> Societies -> Groups -> Individuals

Le Bon saw crowds as a psychological phenomenon rather than a physical one. Individuals can form a crowd simply by having a common cause. This type of influence can easily be found in groups such as:

• Football teams
• Armies
• Riotous mobs
• Religious sects
• Patriotic nations

Of course, crowd influence can also be found in all financial markets. Examples are bull market crowds and bear market crowds. The bulls and the bears each have their own mind (opinions) about the direction of the market.

Tenets Central to Crowd Theory

Le Bon provided two concepts, which have become important tenets in crowd theory:

1. A crowd is something other than the sum of its parts – a crowd has an effective mind of its own
2. Each individual’s behavior is altered by membership to the crowd.

According to British social scientist, Gregory Bateson (1904 – 1980), “mind” is actually a logical process involving all the different aspects of self-organization and learning. An individual’s mind may be regarded as a subsystem of the greater whole, where, in turn, the whole has its own “collective mind” to organize its parts.

On this analysis, each crowd may be said to have a “collective consciousness”.

Emotions and Intelligence of Crowds

The Hungarian-born writer and complex systems theorist, Arthur Koestler (1905 - 1983) offered a physiological reason for why crowd behavior is essentially irrational. Koestler thought that, as crowds come into being, the crowd members’ brain stem and limbic system hold sway. Participants then become primarily involved with instincts, biological drives, compulsive behavior and emotions.

Crowd members are not unintelligent; it is their ability to remain self-aware and think logically that becomes suppressed. Crowds think in terms of simple images and communicate with slogans. The overriding dominance of a crowd’s belief system imposes severe limitations on the quality of data that a crowd will recognize as information.

References:

1. “Forecasting Financial Markets – Technical Analysis and the Dynamics of Price”, Tony Plummer. John Wiley & Sons, NY, 1991.

The reader might be interested in a related article - how efficiently markets disseminate information to market participants and their response to information.

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