Trading Psychology – Herd Mentality

Herd Mentality results in the dilution of I.Q. by the members of a group.  This dilution increases exponentially with the size of the group and the level of emotion common amongst members.  Herd Mentality is the reason why a group of people can abandon reason and descend into madness in a way that any individual of the group would not, it is also a major cause of Contagion.  For this reason it is essential to maintain your individuality when investing.  In doing so you can objectively observe the herd’s behavior and profit from its stupidity.

Herd mentality is not reserved for the stock market; have you ever watched a riot on TV and seen regular people committing terrible acts of violence with a complete disregard for others?  This is a reaction to peer pressure which makes individuals act in order to avoid feeling ‘left out’ from the group.

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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! – Charles Mackay

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French sociologist Gustave Le Bon developed a theory called Contagion (different from Financial Contagion).  It assumes that crowds exert a hypnotic influence over their members.  People find themselves in a situation where they are anonymous and can abandon personal responsibility.  They get sucked up in the contagious emotions of the crowd and can be driven toward irrational, often violent action that most isolated individuals would not attempt.^[1] The main flaw in this theory is that crowd behavior is not necessarily irrational.

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The crowd is always intellectually inferior to the isolated individual, but that, from the point of view of feelings and of the acts these feelings provoke, the crowd may, according to circumstances, be better or worse than the individual.  All depends on the nature of the suggestion to which the crowd is exposed – Gustave Le Bon

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Another theory to explain Herd Mentality is called Convergence.  It suggests that crowd behavior is a product of the convergence of like-minded individuals; that people who wish to act in a certain way come together to form crowds.^[2] Floyd Allport, a man considered the founder of social psychology said “The individual in the crowd behaves exactly as he would behave alone, only more so.”  Convergence theory better explains why not all groups of people behave irrationally but does not explain why some people do things in a crowd that they would not have the courage to do alone.

I agree with both theories in part.  My research suggests that it is the underlying emotions of the crowd that hold the key to understanding its behavior.  If the emotions are negative such as anger, hate, fear, greed etc. then the resulting behavior is best explained by Contagion Theory.  As the negativity and the intensity of the emotions increases the resulting behavior is progressively more animalistic and irrational.

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Examples:

• The Netherlands Tulip mania 1636–37
• New York Draft Riots 1863
• The Roaring Twenties and the crash of 1929
• The Black Monday market crash October 1987
• June 2001 riot by Los Angeles Lakers fans after the Lakers victory over Philadelphia in the NBA Finals
• Run on the Bank of England September 2007

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Stock market bubbles and crashes are great examples of Herd Mentality and Contagion Theory.  They tend to begin and end with extremes of emotion; frenzied buying (Greed) to cause a bubble and then selling in a panic (Fear) to trigger a crash.  Otherwise sensible people act against their better judgment.^[3] Individuals don’t want to be ‘left out’ and rush with the crowd into or out of the market.

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The crimes of Nazism are not the crimes of one nation.  Cruelty a taste for violence, the religion of force, ferocious racialism, are not the prerogative of a period or of a people.  They are of all ages and of all countries.  They have biological and psychological bases which it is by no means certain that we shall escape again.  The human being is a dangerous wild animal.  In normal periods his evil instincts remain in the background, held in check by the conventions, laws and criteria of civilization, but let a regime come that not only liberates these terrible impulses but makes a virtue of them, then from the depths of time the snout of the beast reappears, tears aside the slender disguise imposed by civilisation and howls the death-cries of forgotten ages – Jacques Delarue (The History of the Gestapo)

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However if the underlying emotions are positive such as love, peace, serenity, unity, understanding etc. then the resulting Herd Mentality is better explained by Convergence Theory.

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Examples:

• The majority of weekly Religious Gatherings
• The majority of sporting events
• The majority of music concerts
• Peaceful Protests

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The most significant example of Herd Mentality as explained by Convergence Theory was seen during the Salt Satyagraha.  It was a campaign of non-violent protest against the British salt tax in India lead by Mahatma Gandhi.  There are reports of over 100,000 people at times marching in a spirit of peace, unity and harmony.^[4] These people were suffering racial and financial injustice and had every reason to be angry yet they remained non-violent.

So what has this got to do with making money in the stock market?  Well, it’s the emotions of fear and greed that cause the Wall Street herd to behave irrationally.  In contrast; Gandhi, through maintaining positive emotions and resisting anger and fear, induced 200 million people to maintain their composure and act with a clear mind.  The result was to bring Britain, a world super power to its knees without any violence or financial backing.

To stay separate from the herd we must remain emotionally neutral, resisting both fear and greed.  This is only possible when you know that probability is in your favor.  Then you don’t need to care about the outcome of a particular trade, you can remain detached from the outcome and let the law of averages run it course.

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If you cannot control your emotions you cannot control your money – Warren Buffett

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A fascinating aspect of Trading Psychology is that when the emotional influence on members of a group is low, Herd Mentality evolves into Group Intelligence.

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Even the intelligent investor is likely to need considerable willpower to keep from following the crowd. – Benjamin Graham

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What tactics do you use to remove emotions from your investing decisions?  Have you ever been caught following the crowd?

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Part 1 – Trading Psychology

Part 3 – Group Intelligence

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1. ^ The Crowd: A Study of the Popular Mind, 1896 by Gustave Le Bon.
2. ^ Sociology, 2007 by John J. Macionis.
3. ^ Herd mentality rules in financial crisis by Maggie Fox, Reuters September 30, 2008.
4. ^ Gandhi and Salt Satyagraha, 1981 by S. R Bakshi.