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Taming the Beast: Wall Street's Imperfect Answers to Making Money by Larry Light

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Chapter 12

The Madness of Crowds: Behaviorism

In the 1600s, Dutch investors were crazy about tulips. The good burghers bought up these fragile flowers as if within the petals lay the secrets of life and death. The price of a single tulip could equal that of an Amsterdam house. Tulip mania did not end well for these investors. The flowers wilted, along with many fortunes. How could so many people, a lot of them smart, be so wrong? As Charles Mackay later wrote in his 1841 book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, “Men … think in herds. It has been seen that they go mad in herds, while they only recover their senses slowly, one by one.”

Benjamin Graham’s character, Mr. Market, the excitable chap enthralled to his emotions, shows how easy it is to behave irrationally—and contrary to your best interests. In the depths of the most recent U.S. bear market, March 2009, people bolted out of stocks, when that was the perfect time to buy because stocks were cheap. A powerful rally ensued, yet many investors were, out of an overabundance of caution, on the sidelines and missed it. They had been burned badly in the slump. Projecting that the future would echo the past, these stricken souls were in no mood to risk more pain by getting back into what had hurt them. And this was despite long-standing evidence that markets move in cycles—up will eventually follow down.

For a long while, the prevailing orthodoxy in financial circles was that investing decisions ...

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