by Jim Paul
“That’s it! That’s it!” I screamed. “It’s done. Holy . . . it’s done.”
They had ceased trading in “our stock” — news pending. Somebody was going to pay $60 for this stock that we owned at $35. We went home for the weekend thinking that Monday morning we were going to be millionaires. One of our biggest customers had on ten thousand or fifteen thousand of these options and he called British Airways to find out what it would cost to rent the Concorde — just for us! He actually wanted to lease the Concorde and fly to London to celebrate. We were all going to meet in New York at the Waldorf-Astoria, get on the Concorde and go to London and have a good time. I don’t remember the exact figure, but the rental would have been like $200,000 or $300,000. That kind of money wouldn’t have been a problem considering that we were all going to be multi-millionaires come Monday morning.
Well, Monday morning the stock was still under the news pending restriction but the options opened and they were higher. After about half an hour, the stock finally opened — down $6! The news that came out was “the pending, potential buyout” had been killed. Our options expired worthless. But for a weekend, I thought I was going to be a real six-million-dollar-man.
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Emotions and the Crowd
Perhaps the most frequently cited reason for losses in the markets is emotion. These explanations run the gamut from simply citing greed and fear to others which go into great detail on emotions, their source from early childhood and their affect on you. But examining individual emotions misses the point. Emotions are neither good nor bad; they simply are. They cannot be avoided. But emotionalism (i.e., decision-making based on emotions) is bad, can be controlled and should be avoided. So instead of examining each of the many individual emotions, this chapter will focus on the entity that epitomizes emotionalism: the crowd.
Emotions are very strong feelings arising subjectively rather than through conscious mental effort. As will be shown shortly, the fundamental characteristic of a crowd is that it is exclusively guided by unconscious motives. In other words, it is guided by emotions. If you don’t have conscious control of your actions, then your emotions have control of you. Therefore, in order to understand how emotionalism adversely affects you as an investor, trader or speculator, you have to know the characteristics and behaviors of the crowd. Nineteenth-century philosopher Gustave Le Bon put it this way: “Crowds are somewhat like the sphinx of ancient fable: it is necessary to arrive at a solution to the problem offered by their psychology or resign ourselves to being devoured by them.”30
Conventional Views of the Crowd
1. Runaway Markets
All of us are familiar with the old market sayings about the public and the crowd such as: “Don’t follow the crowd,” “Be contrarian,” “Trade opposite the general public.” But most people don’t really know what a crowd is, much less how to recognize it and still less as to whether they are a part of the crowd. Most explanations of the crowd are actually studies of, or references to, the investing frenzies which have gripped mankind throughout history. For example, in his 1841 book Extraordinary Popular Delusions and the Madness of Crowds, British historian Charles Mackay recounts, among other manias, one of the more famous times in history when the crowd lost its collective head: Holland’s Tulip Mania. In 1634 a speculative boom in Holland’s primitive stock market spilled over into the flower marts, similar to the manner in which the speculative boom in the world stock markets in the 1980s spilled over into the art market. People in all stations of life converted their property into cash and invested it in tulip bulbs. At the peak of the tulip market in November 1634, single bulbs sold for prices equal to ten years’ wages of the average worker.
Looking at such historical speculative episodes in search of common patterns has produced various models which describe the stages of the process at work when a market is driven by a crowd. For instance, in Manias, Panics and Crashes by Charles P. Kindleberger we find The Minsky Model: 1) Displacement — some exogenous event (war, crop failure, etc.) shocks the macro-economic system. 2) Opportunities — the displacement creates profitable opportunities in some sectors of the economy and closes down other sectors. Investment and production focuses on the profitable sectors and a boom is underway. 3) Credit expansion — an expansion of credit feeds the boom. 4) Euphoria — speculation for price increases couples with investment for production/sale.31
Another common pattern used to describe the crowd overtaking a market is: 1) Speculation; 2) Credit expansion; 3) Financial distress; 4) Crisis; 5) Panic and crash.
There are variations on these models, but essentially the crowd has been studied, described and explained in terms of historical events, rather than as a mental process that can happen to individuals. Thus, the crowd is seen as some kind of anonymous they who got caught up in a runaway market.
2. Contrarian Approach
Another way of viewing the crowd is the contrarian approach to the market in which people look for universal endorsement at market tops and capitulation at market bottoms. Contrarians take market positions opposite the crowd. But you can’t always be positioned opposite the crowd. In fact, you probably will be positioned the same way as the crowd at least some of the time because it’s the only way your idea can become profitable; the crowd must come in and move the market the way you were positioned for it to go.
These conventional views of the crowd do not serve our purpose. Knowing the patterns of manias, panics and crashes may be helpful in recognizing when such episodes are beginning to repeat themselves in the market, but these patterns reveal little about an individual’s decision-making process. The patterns describe market events, not the mental state of an individual forming part of a crowd. Since our focus is on market participants rather than historians or economists, we don’t need models to warn us of impending manias or panics in a market. Rather, we need a model to alert us to when we are becoming part of a crowd.
What is a Crowd?
In the ordinary sense the word, crowd means a gathering of individuals regardless of what has brought them together. But according to Le Bon, in his book The Crowd, from a psychological perspective the word means something entirely different. When the sentiments and ideas of all the people in the gathering take one and the same direction and their conscious individual personality disappears, then the gathering has become a psychological crowd.32 It is my contention that this process does not require a gathering of people; an isolated individual who displays those characteristics is, for all intents and purposes, a member of the crowd.
Can you be classified as part of the crowd even if you’re sitting alone in your den following the markets? Yes — if you’re wavering back and forth like a candle in the wind, swayed by every news story or price change on the screen. Are you displaying the characteristics of a crowd in your individual decision-making process? If you are evidencing the tendencies, emotions and characteristics of the crowd in your actions and reactions to the market, then you are making a crowd trade.
The basic distinction between the individual and the crowd is that the individual acts after reasoning, deliberation and analysis; a crowd acts on feeling, emotion and impulses. An individual will think out his opinions, whereas a crowd is swayed by emotional viewpoints rather than by reasoning. In the crowd, emotional and thoughtless opinions spread widely via imitation and contagion.33 Learning the characteristics of a crowd and how it forms will provide a structure which shows how emotionalism affects your decision-making. Once you know the structure, you’ll know what to avoid in order to prevent emotionalism.
Characteristics of a Crowd
There are three main characteristics that describe the mental state of an individual forming a part of a crowd. As you will see, the same characteristics can also be exhibited by an individual making investment and trading decisions.
1. A Sentiment of Invincible Power
The individual forming part o
f a crowd acquires a sentiment of invincible power; the improbable doesn’t exist for the crowd or its members. According to Webster’s dictionary, sentiment is a complex combination of feelings and opinions as a basis for judgment. This feeling of invincible power tends to make a person yield to instincts and emotions that he would ordinarily keep in check. But the crowd is anonymous and anyone in the crowd will shirk responsibility for his actions. In a crowd people do things they wouldn’t ordinarily do, because they are anonymous and feed off the power provided by the crowd. The responsibility that keeps individuals in control vanishes in the crowd. (Witness the actions of fans who storm the football field after a victory and tear down the goal posts.) This is how I was in the bean oil trade. I was invincible. I could do no wrong. As far as I was concerned, there was no question that the trade was going to make $10 million.
2. Contagion
The American Heritage Dictionary defines contagion as the tendency to spread as an influence or emotional state. This is like the spontaneous wave at a football stadium, or the riots which break out in a city after a home team’s championship victory. It’s like being hypnotized or mesmerized. Watching prices change on the computer screen, getting quotes from your broker throughout the day, seeing the stock ticker on the bottom of your TV screen or just being in the market and experiencing prices going up and down can serve as the hypnotist’s watch swinging back and forth in front of his subject. This describes my mental state in the motor home when I was keeping up with the markets on the telephone.
3. Suggestibility
The best way to describe this is the way a hypnotized subject, in the hands of his hypnotizer, responds to the power of suggestion. He is highly suggestible and no longer conscious of his acts. Under the influence of a suggestion, he will undertake the accomplishment of certain acts with irresistible impetuosity. This sounds just like me when I was driving down the Jersey turnpike, glued to my telephone and listening to the changing prices, and when I took the suggestions on the bean oil trade and the stock trades and ran with them. In the special state of fascination (contagion), an individual is in the hands of the price changes on the screen, the words and suggestions of whoever got him into the market in the first place or anyone else from whom he seeks opinions.
The most striking peculiarity presented by a psychological crowd is the following: Once individuals have formed a crowd, however like or unlike their mode of life, their occupation_ their character or their intelligence, that fact that they have been transformed into a crowd puts them in possession of a sort of collective mind which makes them act in a manner quite different from that in which each individual would act, were he in a state of isolation.34 A person in a crowd also allows himself to be induced to commit acts contrary to his most obvious interests. One of the most incomprehensible features of a crowd is the tenacity with which the members adhere to erroneous assumptions despite mounting evidence to challenge them.35 So when an individual adheres to a market position despite the mounting losses, he is a crowd.
These observations explain what happens when you do something you said you weren’t going to do, or fail to do something you said you would do. They also explain why I stayed in the bean oil after I began losing more than I ever had made in the position. It was obviously not in my best interest to take money from other ventures and borrow money to pay for the losses that were accumulating. Why would I let a once profitable position go to the point where I actually had to borrow money to stay in the position? If you had posed that possibility to me in 1973 or 1976, or even in August 1983, I would have completely rejected the notion that I could ever do such a thing. If you have ever had a position on and intended to do one thing but actually did something else, then you were a member of the psychological crowd and made a crowd trade — whether you knew it or not. Otherwise, you would have done what you originally intended.
The point is, that in addition to the traditional views of the crowd in the markets, there is also such thing as a crowd investment or a crowd trade that an individual can make, even without the presence or influence of other people. The similarities between a psychological crowd and a losing market participant are striking. Remember, it is not a function of a quantity of individuals which determines if a psychological crowd has formed. Rather, it is a function of the characteristics displayed. If a person is exhibiting these characteristics, then he is part of a psychological crowd and is making crowd trades.
The market doesn’t even have to be frothy for an individual to make a crowd trade, nor does it have to fall into either of the crowd models described earlier. The market can just be going sideways, and he can still be making a crowd trade, if he is exhibiting the special characteristics of crowds such as: impulsiveness, irritability, incapacity to reason, exaggeration of sentiments, absence of critical judgment, etc. If this isn’t the profile of an emotional (and losing) market participant, then nothing is. It describes me perfectly when I was in the bean oil trade and the takeover stock trade, not to mention many other trades.
The two models below are adapted from Le Bon’s book, The Crowd. While he was interested in the processes and characteristics of mob behavior from a sociological point of view, we are interested in how those processes and characteristics exhibit themselves in individuals when making market decisions.
Two Psychological Crowd Models
Delusion Model
The delusion model describes the process an individual becoming part of a psychological crowd before he has a position on.
1. Expectant Attention; 2. Suggestion Made; 3. Process of Contagion; 4. Acceptance by All Present. This model illustrates exactly how the net loser participates in the markets. He is ready! Because he is so anxious to make money, he is in a state of expectant attention. He hears a tip or a casual comment about the market; enthusiasm is contagious and he goes into a hypnotic-like trance, takes the tip as gospel and acts on it. Compare this to when you’ve made hasty, impulsive, spur-of-the-moment decisions or followed someone else’s tip to get in or out of the market I went through the same process when I entered the takeover stock trade and the bean oil position In both of these instances, as well as many others, I was in an expectant state of attention; ready to make money. Once the trades were suggested to me, a process of contagion took over and I acted.
The reason why people who try to make back losses quickly lose again is because they are in an expectant state of attention ready to pounce on any trade suggested. This makes them part of the crowd, emotional to the extreme and bound to lose.
The Illusion Model
The illusion model accurately describes the process of an individual becoming part of a psychological crowd after he has a position on.
1. Affirmation; 2. Repetition; 3. Prestige; 4. Contagion. Consider the following scenario. An opinion about the market is expressed (affirmation) either by you or someone else. It gets repeated (repetition) to others. Friends ask what you think about the markets and you repeat the opinion, selling yourself on the idea once again. Next, prestige comes into play. Prestige is a sort of domination exercised over us by an individual, a work, an idea or a wish. It entirely paralyzes our critical faculty and fills us with wonderment. The market is going your way; you look like a hero; you’re so smart (prestige); you have the adulation of your peers. Emotionalism overwhelms you (contagion). You’re hypnotized.
The illusion model can also be applied to losing trades if the prestige involved comes from your daring actions and being able to take the punishment of a losing position. Sure, the market is against you, but you’re courageous and you can take it. The market is wrong and will turn around. You take pride in your courage to go against the crowd because according to market lore, the crowd is supposed to be wrong. People marvel at your ability to stay with a losing position. Once again you become hypnotized (contagion) and are out of control. The trade will end only when you are forced out by external forces (e.g., money, family, margin clerk). This is exactly what I did once the b
ean oil position started going against me. Why else would I let the once profitable bean oil position erode to the point where I’d basically lost my prior life?
Emotions
Recall from basic economics that markets exist to satisfy the wants and needs of consumers. This means people make purchases for only one of two reasons: to feel better (satisfying a want) or to solve a problem (satisfying a need). Trying to do the former in the financial markets is dangerous. If you are in the markets to achieve a certain emotional state or create self-esteem, then you have some psychological disorders and need to see a therapist. Just as compulsive gambling, which is a personality disorder, isn’t the focus of this book, neither are the other psychological pathologies. Our discussion only addresses the normal emotional ups and downs of participating in the markets, not the psychological disorders. Remember, emotions per se are neither good nor bad; they just are. It’s emotionalism we are trying to avoid.
Hope/Fear Paradox
Psychologists and psychiatrists usually advise against suppressing emotions, and suppression usually involves negative emotions. Rarely, if ever, are patients treated for suppressing positive emotions. Surprising as it may sound, however, both positive and negative emotions can have detrimental effects on your decisions and performance in the markets. To see why this is true, let’s examine the ailments of hope and fear and their unique link to the crowd.
