Wednesday, May 16, 2007

The madness of crowds

Today, let's explore the above phrase very simply and aptly titled "the madness of crowds". This phrase actually came from Sir Isaac Newton (yes, the sciency guy who gave us the three laws of motion, but was a tad slow in getting to the part about relativity !) when he lost a ton of money in the South Sea bubble (see this link Newton lost a lot of money in the bubble and speculative mania, which led him to remark that he could predict the motion of heavenly bodies, but not the madness of people.

This concept basically ties back to the greater fool theory which I blogged about some time back. Crowd or herd mentality comes about when many people jump into a "hot" counter or hyped-up stock, thus creating the "bubble". More and more speculators, seeing the amazing and meteoric rise in the share price (sometimes within seconds), feel a compelling urge to jump in as well. And so the madness builds up, as more and more ignorant people pile into the counter, pushing it higher and higher, resulting in the greater fool theory being in play. When the party's over, those still left in the dark hall will probably not be able to find their way home, and even the coaches have turned to pumpkins (akin to Cinderella). Warren Buffett warns of this behaviour when he mentions that such madness is akin to dancing in a room without clocks. Everyone knows that the party ends at midnight, but everyone wants one last dance. But in this room without clocks, no one wants to leave and no one knows exactly when to leave. Thus, a great number end up getting "trapped" and burnt.

As I was observing the market today, I had quite a good first-hand experience with crowd madness. Lottvision was massively played up today and it jumped up 11 cents from $0.505 to $0.615, on a volume of 141 million shares ! The SI forum was alive with people patting each other on the back for the "quick" and "instant" profits made from this sentiment driven rally. Others even proudly admitted moving "in and out", thus making profits a few times over. Yet others proudly proclaim that they bought in just before closing, to wait for the next burst of energy to push the counter past $1.00.

This is just one simple example of madness, and irrational exuberance. Everyone knows the company is loss-making and has no fundamentals to speak of. Even the new core business of lottery machines has yet to formally take of, but people are already talking excitedly about super profits and massive gains. It doesn't take a genius to figure out that inflated expectations are akin to a big bubble blown out of chewing gum. The chewing gum bubble will burst in the end, leaving a sticky mess, and the child will grow tired of sucking on the now-tasteless gum and throw it away.

This is exactly how the crowd reacts, moving from one stock to another, akin to a butterfly visiting flower after flower to gather nectar. Needless to say, this practice can be lucrative in a bull market and sudden rally, but what happens in a crash ? People who think they are so smart get caught off guard; imagine buying 200 lots to contra and the price crashes 10 cents, that's a $20,000 contra loss. All it takes is one BAD contra trade to wipe all many small good ones.

Thus, is it worth the effort ? Buffett mentions that most people cannot resist the temptation to trade in and out of the market, because they liken activity to intelligence and profit-making. Actually, the best profits I've known have been the ones where I bought into a good company, and SAT ON MY BUTT doing nothing at all. This may sound strange to a reader unfamiliar with value investing, but that's precisely what happens.

Value investing can guarantee steady returns, year after year, through all kinds of markets. In bull markets, historically, traders and speculators have outperformed value investors (this is a natural thing, as value investors are conservative and do not take unnecessary risks). But in a bear market or a market trading flat, value investors are the ones who reap the most benefits. This is because of the margin of safety principle and the fact that they concentrate on the business, not the share price.

For more information on value investing, I do recommend a book called "Value Investing for Dummies", which I have found in most good bookstores.

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