The Influence of Crowd Psychology on the Investor

In 1895, Gustave Le Bon published his best-known work, The Crowd: A Study of the Popular Mind. At the time, Le Bon enhanced the understanding of crowd psychology by researching and proposing several theories of how our beliefs and actions are altered in a “crowd” state.

How can a book from 1895 be useful to investors today? The basic idea is that our minds have not changed over the last 100 years. We still respond to the same emotions and biases as our ancestors. We repeat the same mistakes, generation after generation.

The influence of the crowd has never been more relevant. We must protect our mind from the opinions and ideas we accept. The information deluge is constant. It’s a fuzzy, almost imperceptible line to separate our own opinions from the opinions of the masses. That battle is consistently lost by unprepared investors who let their guard down when making investment decisions. 

Because we, as humans, are susceptible to overconfidence, we assume the crowds have no influence on our mind. We are too confident - it’s always other people’s problem, not ours. We are way too smart to be influenced by crowds.  I wish that were true, but studies clearly indicate otherwise.

How do we fight against becoming the “crowd” and learn to combat the frivolous and dangerous ideas?

Based on Le Bon’s work, I have created 8 lessons to prepare your mind against crowd behavior. (Note: all quotes attributable to Le Bon’s work, The Crowd)

It’s not an easy or painless endeavor. As Le Bon stated, “Science promised us truth, or at least a knowledge of such relations as our intelligence can seize: it never promised us peace or happiness.”

Understanding crowd psychology is not comfortable. We might not like the journey, but ignoring science dooms us to forever remaining in the crowd.

1.       The Struggle to Maintain Independence

It is only by obtaining some sort of insight into the psychology of crowd that can be understood how slight is the action upon them of laws and institutions, how powerless they are to hold any opinions other than those which are imposed upon them, and that it is not with rules based on theories to pure equity that they are to be led, but by seeking what produces an impression on them and what seduces them.

The goal is to understand how a crowd imposes its will on our minds. The first step is always understanding the process. The second step is creating a habit or framework to counter crowd effects.

We see that the disappearance of the conscious personality, the predominance of the unconscious personality, the turning of feelings and ideas in an identical direction by means of suggestion and contagion, the tendency to immediately transform the congested ideas into acts. These receive the principal characteristics of the individual forming part of a crowd. He is no longer himself, but has become an automaton who has ceased to be guided by his will.

Whenever we self-identify with a crowd, whether consciously or unconsciously, we strip away our ability to remain objective and rational. It’s evident in politics and religion. Ever try to have a logical political or religious debate? How quickly did it devolve into an anecdotal argument full of personal attacks and red herrings? Most people quickly move into defensive positions and start to defend their identities, rather than the argument. Once that happens, all reason disappears and no progress is made.

The crowd is at the mercy of all external exciting causes, and reflects their incessant variations. It is the slave of the impulses which it receives. Isolated individuals may be submitted to the same exciting causes as a man in a crowd, but as his brain shows him the in advisability of yielding to them, he refrains from yielding. The truth may be physiologically expressed by saying the isolated individual possesses the capacity of dominating his reflex action, while crowd is devoid of this capacity.

Remember, the crowd doesn’t seek the truth; it’s in constant search of excitement, novelty, and reward. If you understand that, you are prepared to understand events with a free mind. By remaining outside the crowd, you retain your capacity to evaluate the situation independently.

It’s never a problem to agree with the crowd, as long as you come to that decision through independent means. And doing that is never easy.

2.       Excitement and Novelty Drive Belief

The exciting causes that may act on crowds been so buried, and crowds always opening them, crowds are in consequence extremely mobile. This explains how it is that we see them pass in a moment from the most bloodthirsty ferocity the most extreme generosity and heroism.

When financial crowds operate in extreme directions, the market moves defy logic. What excited a crowd one day is erased with a terrifying reversal in sentiment the next day. These actions are unpredictable and wild. Although we try in vain to understand what is happening, it’s sufficient to attribute these moves to crowd behavior. Don’t waste time and energy trying to dissect the “meaning” of what these moves mean. There is no meaning, other than investors are all behaving under the spell of crowd psychology. While other factors, like leverage, enhance these effects, the root cause is always the crowd on one side of the trade.

They may be animated in succession by the most contrary sentiments, but they will always be under the influence of the exciting causes of the moment…Still, though the wishes of crowds are frenzied they are not durable. Crowds are as incapable of willing as of thinking for any length of time.

On the positive side, the extreme swings don’t last. Fundamentals eventually matter, and the crowds that operate irrationally eventually run out of assets to sell or run out of money to buy. The best course of action is remaining patient and vigilant. These are the opportunities to take advantage of the crowd, by using their instability against them.

3.       Crowd Beliefs Shut Down Thinking

A crowd is not merely impulsive and mobile. Like a savage, it is not prepared to admit that anything can come between its desire and the realization of its desire. It is less capable of understanding such an intervention, a consequence of the feeling of irresistible power given it by its numerical strength. The notion of impossibility disappears from the individual in a crowd.

Investors during the 2000 tech bubble and the 2006 housing bubble understand why the notion of impossibility disappears from the investment crowd. During those bubbles, tech and housing assets were viewed as can’t miss opportunities, and no amount of rational thinking could prevent investors from believing it was different this time. These assets couldn’t fail because of new paradigms, due to the Internet emergence in 2000 or the unending real estate boom in 2006. Owning these assets and watching them rise reinforced the belief that these assets couldn’t go wrong. But they did, and in a big way.

The improbable does not exist for crowd, it is necessary to bear the circumstance well in my to understand the facility with which are created and propagated the most improbable legends and stories…The simplicity and exaggeration of the sentiments of crowds have for result that a throng knows neither doubt nor uncertainty.

Legends and stories, not facts and data, drive investment booms and busts from healthy to extreme. It’s the stories that convince us of the invincibility and permanence of new ideas. During a bull market, our minds run wild with the possibilities of fantastic gains and newfound wealth. During a crisis, we believe everything is going to zero and assume permanent financial destruction.

The commonality behind both situations is our reliance on stories, rather than relying on factual research and historical lessons. We quickly dismiss any logical approach, because we’ve attached our opinions to the movement of the crowd.  

Whether the feelings exhibited by a crowd be good or bad, they present the double character being very simple and very exaggerated. On this point, as on so many others, and individual in a crowd resembles primitive beings.

We become primitive, in the sense we abandon our developed cognitive processes and let our reptilian brain direct our actions. Our primitive brain was well-designed for living 2,000 years ago, but has not adapted to the modern financial world. Because fear and greed operate on our basic, primitive minds, we must deliberately engage our higher cognitive mind to think clearly.

4.       Emotion Dominates Facts and Evidence

An individual may accept contradiction and discussion; a crowd will never do so.

The chain of logical argumentation is totally incomprehensible to crowds and for this reason is permissible to say that they do not reason or that they reason falsely and are not to be influenced by reasoning.

Crowds dismiss all alternative explanations and contradictory evidence. There are excuses for everything, and no amount of facts or reason will persuade a crowd.

Evidence may be accepted by an educated person, but the convert will be quickly brought back by his unconscious self to his original conceptions. See him again after the lapse of a few days and he will put forward a fresh his old arguments and exactly the same terms.

We can educate, train, and then educate some more, but still never escape the grasp of the crowd. It takes persistent training to re-wire our brains to instinctively recognize and fight the influence of the crowd. It doesn’t happen overnight.

I’ve personally experienced and seen others attempt to change behavior by just adding more information and assuming that will change behavior. Because our behavior is based on cognitive processes evolved over millennia, it’s going to take more than new info to make the change. It’s about using new info to transform habits into permanent behavior change.

That’s why you see investors make the same, repeated mistakes. We can spend all day convincing people of one thing, only to have them revert back a day later. The reason is two-fold. It’s the brain’s way of resisting change and reflects our ill-designed attempts to convert behavior. Permanent, long-term behavior modification requires repeated exposure to live training. Anything else is futile.

A longtime is necessary for ideas to establish themselves in the minds of crowd, but just as long a time is needed for them to be eradicated. This reason crowds, as far as ideas are concerned, are always several generations behind learned men and philosophers.

When we think of “learned men and philosophers” within investing or business, we gravitate toward the those who have proven their investing acumen over decades. JP Morgan, John Rockefeller, Andrew Carnegie, Ben Graham, Warren Buffet. All exceeded their generation by operating outside of the normal crowd state. The goal is to incorporate the lessons of the historic greats and operate with different principles than the crowd. It’s not enough to know different information. We must operate with a different set of principles than the crowd: independence, grit, intelligence, foresight, contrarianism, and persistence.

It is not than the facts and themselves that strike the popular imagination, but the way in which they take place in our brought under notice. The epidemic of influenza may very little impression on the population because they happened a little at a time, as opposed to one giant event that would’ve caused an uproar among the population.

The hardest beliefs to challenge can be the most non-obvious. Incorrect beliefs that have been learned gradually often lack the vividness that would normally cause us to re-examine those beliefs.

5.       Strong Beliefs are Fine, But be Open to Change

A person is not religious solely when he worships a divinity, but when he puts all the resources of his mind, the complete submission of his will, and the whole sold ardor of fanaticism at the service of a cause or an individual becomes the goal and guide of his thoughts and actions.

It’s fine to have beliefs, and strong beliefs at that. But all beliefs need at least 3 qualities:

1.       Evidenced based – valid, fundamental data should support your beliefs. Data is not always perfect and is never guaranteed, especially when thinking about the future. But there is no room for mythical or untested beliefs to drive investing decisions.

2.       Open to modification or reversal – strongly held beliefs should be changed when the weight of the evidence tips to the side of change. Beliefs should be held tentatively, ready to be changed when sufficient data/evidence is presented. Some beliefs may change daily (for example, because prices move daily, what is a terrible deal at one price is a great deal at another price) or may be rarely change (the idea that investing and saving for the future is a good thing). There’s no easy answer to this, other than to evaluate each belief on its own when new evidence is presented.

3.       Separate beliefs from your identity – if you attach beliefs to your identity, personality, or other personal trait, you run the risk of keeping beliefs not because they are correct, but because you become more interested in defending your ego and reputation. For example, if you always self-identify as bullish and optimistic on the stock market, it’s challenging to change your mind when the market is overvalued, because you have created a reputation and identity as someone who is perpetually bullish. It’s hard to have the guts to change your mind when your identity is something else.

You’ve created cognitive dissonance when your identity is telling you one thing (buy stocks) and the evidence is telling you another (sell stocks). The identity almost always wins, because our minds have a bigger interest in protecting our identity than searching for the truth. This is deadly for investors. Don’t take permanent stances in investing. Don’t create reputations or identities that make it painful to change your mind.

The masses have never thirsted after truth. They turn aside from evidence that is not to their taste, preferring to deify error, if error seduced them. Whoever can supply them with delusions is easily their master, whoever attempts to destroy their illusions is always their victim.

Many investors are eternally searching for the magic formula or guaranteed path to riches. They spend thousands of dollars on programs and systems that supposedly “reveal” the inside secrets of investment success. When viewed through a logical, rational lens, these claims are ludicrous and insane. But when viewed through the “crowd” lens, these programs make perfect sense. They appeal to investor’s desire for a can’t miss system, no matter how incredulous.

Investors must recognize when they fall under the spell of delusional, yet seductive systems that promise riches. It’s an inherent bias we all need to fight, and the minute we let our guard down, we succumb to our primal, crowd-based motives.

The experiences undergone by one generation are useless, as a rule, for the generation that follows, which is the reason why historical facts, cited with a view to demonstration, serve no purpose.

There are several reasons why investors forget the lessons of the past.

1.       We assume the people in the past were unsophisticated/unintelligent. We will never make those same mistakes. Wrong. While we have certainly advanced as a society, poor investing decisions in the past were usually never the result of a relative disadvantage in IQ or decision making. While we may know more today, we are also making decisions in a world that is more complicated and uncertain than it was in the past. In absolute terms, we may have an edge, but we are playing a more complex investing game. We are in a tougher environment, so we are relatively no better off.

2.       Hindsight is 20/20 – With the benefit of hindsight, we create all sorts of reasons why we wouldn’t have made those same mistakes. But it’s always obvious in retrospect, never in real-time. If you think it’s so easy, write down some can’t miss ideas today, and track those over a course of 3-5 years. Chances are you will have as many misses and wins, if not more misses. It’s a simple experiment to prove how hard it is to move hindsight into foresight.

3.       We assume the environment today is more predictable because we have access to more immediate information. Yes, we do have more information, and some of it is extremely valuable. However, that information comes with a lot of noise (data or information that has no predictive use or functional utility). And the catch is, it’s difficult to separate those two groups. We often get a mess of data and try to figure out what is news and what is noise. There’s never a clear answer, because what is useful in one environment is useless in another. You must be very clear about what edge you have and understand your circle of competence. Once you start to drift outside your core competence, you make all sorts of mistakes, including mistaking noise for news.

 6.       Understand the Psychological Tricks Preying on Your Mind

We’ve already discussed the problems dealing with unpredictable and complex investment situations. But there is even more trouble for us.

The financial industry promises to help investors navigate the complex investment world. Of course, they don’t expect to do that for free. It’s a lucrative industry that spawns many charlatans, con men, and promotors who want a slice of our wealth in exchange for bogus market-beating systems and hot stock tips.

These are both people and corporations full of bad advice and misdirection. To defeat them, you need know the tricks they play. Le Bon suggests several situations and triggers to watch for to understand when you are being pulled in the wrong direction.

We have already shown the crowd or not to be influenced by reasoning, and can only comprehend rough and ready associations of ideas. The orators who know how to make an impression upon them always appealing consequence to their sentiments and never to the reason. The laws of logic have no action on crowds.

The first idea: understand they always appeal to emotion, not reason. They sell with stories and dreams, not verified facts and evidence. If they based their approach on raw evidence, 1) their performance/client results look terrible, and 2) it does little to inspire wealth and riches when looking at cold numbers. They need to get you excited to get rich, or at least distract you from the flaws and risks in their argument. So always separate fact from story.

Given to exaggeration and its feelings, a crowd is only impressed by excessive sentiments. An orator wishing to move a crowd must make an abusive use of violent affirmations. To exaggerate, to affirm, to resort to repetitions, and never to attempt to prove anything by reasoning or methods of argument well known to speakers at public meetings.

It is terrible at times to think of the power that strong conviction combined with extreme narrowness of mine gives a man possessing prestige. It is nonetheless necessary that these conditions should be satisfied for man to ignore obstacles and display strength the will and a high measure. Crowds instinctively recognize and men of energy and conviction the Masters they are always in need of.

Two elements persuade a crowd. Strong conviction and extreme narrowness. Strong conviction delivers an overwhelming aura of superiority and challenges your ability to think independently, even if the conviction is baseless. Extreme narrowness reinforces that there is only one solution and path forward. It leaves no room for alternative explanations or doubt.

7.       How False Beliefs Spread

The first is that as the old beliefs are losing their influence to a greater and greater extent, they are ceasing to shape the ephemeral opinions of the moment as they did in the past. The weakening of general beliefs clears the ground for crop of haphazard opinions without a past or future.

As economic and investment cycles progress, investors abandon common-sense, fundamental principles and gravitate towards riskier, crowd-like behavior. There is always a rationale why the old beliefs don’t matter and the new ideas must be the new answer.

A second reason is that the power of crowds being on the increase, and this power being less and less counterbalance, the extreme ability of ideas, which we have seen to be a peculiarity of crowds, can manifest itself without let or hindrance.

As ideas spread, they build momentum and a cult-like power that begins to defy reason and logic. Unfortunately, these ideas don’t need any extra push when they start to spread. They build their own momentum through the explosive exponential power of networks.

8.       Why We are Doomed to Repeat Our Mistakes

Judging by the lessons of the past, and by the symptoms that strike the attention on every side, several of her modern civilizations have reached that phase of extreme old age which precedes decadence. It seems inevitable that all peoples should pass through identical phases of existence, since history is so often seem to repeat its course.

One of Le Bon’s final lessons is the idea that humans continue to repeat the same mistakes of the past. No matter how much we improve our understanding, intelligence, or technology, we have ingrained biases and tendencies that we can never permanently overcome. Due to laziness and ignorance, we assume these lessons don’t apply to us, because it’s so hard to create an outside, objective filter to view our own actions. Even though we can’t remove them, we can circumvent and avoid the consequences by deliberately understanding the underlying causes. The key word is deliberate, because just adding more information will not work. We need a conscious effort to understand the historical lessons and design ways of countering the effects of crowd-like behavior.