Performance Perspectives Blog

Extraordinary Popular Delusions and the Madness of Crowds

by | Feb 28, 2012

Last November’s WSJ’s had a Jason Zweig article in which he reminded us of Charles Mackay’s ’41 book on market bubbles, whose title serves as this post’s title. He pointed out how the author himself was fooled, just shortly after his book was published, in believing the “absurdly unrealistic projections of future growth” for railway stocks. Others, too, who have cautioned against bubbles often fall victim.

Investing is often equivalent to the “prisoner’s dilemma,” from game theory. Just recall for a moment how housing took off. Didn’t you see at least one property whose value appeared completely absurd to you? But, the reality was that the price continued to rise! And so, were you the fool for not buying at the “absurdly high” price, but still below what it ultimately sold for (before tumbling)? Academic research has many articles on this topic, but as I recall, knowing you’re in a bubble can be very difficult (impossible, perhaps?), and there is even debate as to whether you can tell when a bubble occurred!

No one wants to miss out on a rising market; to watch your friends accumulate great wealth (on their investments in growth stocks, real estate, or even tulips) can be quite depressing. Thus the dilemma.

What one has to be wary of are those who make fantastic claims about the future. Unfortunately “outlandish claims” only appear outlandish after the fact. We often experience what seems to be outlandish, only later to find out that it wasn’t; likewise, what seems to make sense often does not. Surely many would have thought it outlandish to think that the esteemed veteran of Wall Street, Bernie Madoff, would have been a crook, or that OJ Simpson a murderer. And who would have thought that the Jets would have won the Superbowl in 1969, or for that matter, the Giants this year (after their less than stellar regular season).

More fuel, perhaps, for a challenge to placing too much stock in any one’s predictions.