The Pied Piper and the Crowds

The Pied Piper and the Crowds (First blog Posted in March 2008)

This is our maiden effort to put across our views on the current market scenario. We would like to make this more regular in the times to come, though in what frequency, is something we have not decided yet.

First, a few rules that we would like to observe (we will spare you the pain of going through these in the subsequent articles): First, while we might talk of sectors or even select companies to put forward our viewpoints on certain matters, we would like, as far as possible, to avoid giving direct recommendations on stocks – the so-called ‘tips’.

And if this has not already made some of you lose their interest in this write-up, then the second thing that we would like to avoid is forecasting which way the market will move forward – something which any professional in our field is asked perhaps the most number of times. As Warren Buffett writes in his 1980 letter to the shareholders: “We believe that short-term forecasts of stock or bond prices are useless. The forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”

The third rule is that we will avoid jargon since the audience is likely to be from diverse backgrounds. But we will quote liberally from some of the books, articles or talks etc of various experts in the field.

The topic that we’d like to take up this time is relevant to times of depression as well as a boom: Crowd behavior. Related to this is the notion of the so-called experts who get quoted in newspapers giving their views on the markets etc.

There is so much that has been written about the madness of crowds and yet it’s a wonder that this is something which repeats itself over and over again.

The great classic in this respect of course is Charles Mackay's ‘Extraordinary Popular Delusions and the Madness if Crowds’, which is religiously stacked in every professional investor's bookcase. It mentions: "Men, it has been well said, think in herds. It will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." Friedrich Nietzsche wrote:" Madness is the exception in individuals but the rule in groups.”

This disdain for crowds is deeply embedded. There is the old saying,: "None of us is as dumb as all of us."

There’s no gainsaying that humans learn everything through imitation. They are either influenced by someone’s company or they put someone as their ideal and follow them, making progress or taking inspiration from them. It’s a fact that if a human is not taught a language and is kept amongst the animals where no human language is spoken in front of them, then they won’t be able to speak any language too. Animals don’t have that problem – try keeping your pet dog in isolation from other dogs and see if doesn’t bark!

This of course means that humans are subject to emotional extremes of euphoria and despair. Investors and specula­tors run the gamut from greed to fear as they passionately and blindly stam­pede after markets and prices. From time to rime this leads to bubbles which eventually burst. And this is followed by the bear market when despondency rules every heart and mind.

This has manifested itself many times over in the financial history – right from 1637 when Dutch speculators saw tulip bulbs as their magic road to wealth (this was a time when, it is said, a bulb of no previously apparent worth might well have been exchanged for a new carriage, two grey horses and a complete harness), to the South Sea bubble when even the British Government was involved into something which became a mass market hysteria, to the recent times of the tech bubble of 2000 and of course the most recent bull run on some stock markets.

Problem is that the bubbles burst sometime or the other. And when they do, it causes pain on the other extreme. When would the burst happen, or what will prick that bubble is something that no one can hypothesize on in advance – though many will give their opinions on it. It can be any reason, but the common denominator is that market participants are not only brought down to their senses but several of them lose whatever they have in the process. Of course there will be reams written post the event which will attempt to rationalize the fall.

One reason for such a downfall is what was popularized by Nassim Taleb as The Black Swan event in his book aptly called, The Black Swan. The basic concept behind this is that everyone thought swans could only be white in color. That’s until they saw black swans when Australia was discovered.

This concept illustrates a severe limitation to our learning from observa­tions or experience from the past. One sin­gle observation can invalidate millions of confirmatory sightings of white swans.

A Black Swan is therefore a very low probability, but an extremely high impact event. Pearl Harbor, the fall of the Soviet Union, September 11, 2001 etc. are all examples of this.

The thing about Black Swans is that they are totally unpredictable. Unfortunately, it can strike when we are the least prepared for it. In his book, Taleb gives the example of a turkey which is fed everyday. Every single feeding will firm up the bird’s belief that it is a general rule of life to be fed every day by friendly members of human race. Then on the afternoon of the Wednesday before Thanksgiving, something unexpected happens to the turkey. Taleb points out that the Turkey’s confidence was the highest when the risk (closest to Thanksgiving) was also the highest.

During the recent run up in the stock market, many, including big funds, would have felt like that Turkey.

Taleb correctly points out that when investors assess risk while investing, they do not include the possibility of the Black Swan. As per him, "We don't learn that we don't learn."

What we can do to avoid losses in such an event is a different topic and we might take that up some other time. The point is that the instance of the Black Swans are completely unforecastable. As was a bubble in the first place.

So if everything is so unpredictable, then how reliable are the so-called expert opinions? Well, there is increasing evidence that relying on expert opinion for advice is a loser's game. Philip Tetlock, a psychology professor, looked at this aspect in his book called ‘Expert Political Judgment How Good Is It? How Can We Know?’ Tetlock, over a period of 20 years, tracked 284 experts who made 82,361 forecasts on diverse topics ranging from politics to economic trends. He concluded that Human beings who spend their lives studying the state of the world are poorer forecasters than dart-throwing monkeys, who would have distributed their picks evenly over the available choices of answers.

Tetlock also found that specialists are not significantly more reliable than non-specialists in guessing what is going to happen in the region they study. Knowing a little might make someone a more reliable forecaster, but Tetlock found that knowing a lot can actually make a person less reliable. No wonder Warren Buffett does not like to stay anywhere close to the financial hub of the country. He doesn’t want his judgment colored by listening to every market whisper.
Back home in India, we have our own share of such forecasters. While as recently as December, no rise in the stock market was high enough, as of now they are running over themselves in forecasting that the markets will be beaten back to 2006 (and maybe even earlier) levels. Notwithstanding the fact that India is one of the brightest spots across the world as far as growth in concerned.

Prediction is one of the pleasures of life. Conversation would wither without it. Hence the tendency of experts is to ‘draw an arrow on the trend chart’ and ensure that they say nothing which is untoward or different. But when they are proved wrong, which happens every once in a while, they seldom admit to it – rather they would blame it on new facts available to them. This is called cognitive dissonance.

Well, as we mentioned at the start, we don’t like to forecast the market. As someone has said, no one has managed to time the markets, except the liars. However, one can learn a bit from the past, especially the past mistakes. But be careful - as Nietzsche said, “Ignore the past and you will lose an eye. But live in the past and you will lose both of them.”