Two books point out the inherent challenge of the Markets. The irony lay in their titles: they seem to be inconsistent, polar opposites — but they are not.

The first is a classic: Extraordinary Popular Delusions & the Madness of Crowds, first published by Charles MacKay in 1841. In the intervening 163 years, I see no basis for believing that Human Nature has changed much. Indeed, I doubt there will be any appreciable change in mankind’s fundamental nature over the next 163 years. (After that, between biomechanical networked implants and genetic tinkering, its anyone’s guess).

If you believe in the Madness of Crowds, then you may find shorting into bubbles to your liking, buying capitulations a viable strategy, and making contrarian plays where possible; If you “buy when there is blood in the streets,” then this is the book for you.

The other work is called: The Wisdom of Crowds by James Surowiecki. If expressions such as “Don’t fight the tape,” Go along to get along, and “The trend is your friend” appeal to you, than this book has your name on it.

Now here’s where things get funky: Not only are these books not mutually inconsistent, they are actually somewhat complimentary to each other.

They merely reflect different phases of markets. Bull markets start out from periods of disbelief, doubt, and discomfort. After a period of time, the fear levels dissipate. More people buy in. Economies expand, situations improve, the market moves higher. There’s still some levels of disbelief, naysaying, FUD.

The next leg up is caused by people who now fear they are missing the easy money. Buyer’s start chasing stocks. Things get a bit extended, but not terribly so. People who have been waiting for a pullback decide it ain’t gonna happen, and jump on board. There are some signs of froth, but nothing too crazy. So far, the Wisdom of crowds has been on display.

The next phase is where that wisdom starts to dissipate: The good economic times have been rolling. The market has been humming along for quite a few years now. The more people talk about it starting to get overheated, the higher it goes. Those who missed the more advantageous entries are getting panicky. The long side is starting to get crowded. Examples of absurd valuations are everywhere. THings are getting crazy.

New technologies breed new rules. Someone, somewhere utters those fateful words: “Its different this time.”

Deep down inside, you know its not. But still, how can you miss this? The real pile has just started. All common sense is out the window, as Wisdom morphs into Madness

Guess what happens next . . . ?

Sources:

Charles MacKay: Extraordinary Popular Delusions & the Madness of Crowds

Extraordinary Popular Delusions & the Madness of Crowds

James Surowiecki: The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations

The Wisdom of Crowds

Category: Books, Finance

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3 Responses to “Wisdom versus Madness”

  1. dsquared says:

    Anyone who answered “a crash” is of course dead wrong. What happens at this stage is the final “melt-up” phase, also known as “Wave 5″ to the Elliott crowd or “distribution” to Dow theorists. It’s this final phase – when the mugs whose job is to provide liquidity to the early investors have to be given paper profits to compensate them for their real losses – that usally has fundamental analysts tearing their hair out.

    Any readings in the books should be supplemented by the fantastic sociological work “On Cooling the Mark Out”.

  2. Crowds: Their Wisdom and Delusion

    Barry Ritholtz has a nice post on two books that look at the wisdom and the delusion of crowds….

  3. Bradley Andrews says:

    Anyone interested in reading Extraordinary Delusions can find the full text in 3 parts online at Project Gutenberg