It is perhaps that time of the market cycle when we do feel the madness of crowds, at least when it comes to the Indian markets. The positive view on the Indian economy has become increasingly consensus with hardly any attempt to poke holes in the India story. This is even more apparent with flows into small and mid-cap funds, which today account for majority of flows into the market, even amidst small cap fund managers recommending caution. In this short podcast (with a transcript) with Barry Ritholtz, the eloquent Michael Mauboussin talks about the psychology that drives this herd behaviour and as a corollary why it is so hard to be a contrarian.
He talks about how the crowd is right most of the time but how this same wisdom of crowds can turn into madness of crowds at times:
“And when our crowds [are] smart you need three conditions – diversity, so heterogeneous points of view, aggregation – some way to bring that information together – exchanges do that perfectly and incentives, which are rewards for being right and penalties for being wrong.
So that’s the wisdom of crowds. Well, we know there’s the madness of crowds too, so how does that come about? And the answer is, when one of those three conditions are violated, and by far the most likely to be violated, is diversity. So rather than us thinking independently, we correlate our views. And so that’s, I think the biggest thing we need to think about is when are we all thinking the same way we, when are we all standing on the same side of the ship?”
Organisations are increasingly looking to build diversity in their teams not just from a social perspective but to become more effective in decision making by avoiding such group think, which can lead to ‘madness’.
But when you do spot the madness of the crowd, why is it so hard for us to go against it? Blame it on evolution.
“if you think about primates and humans in particular, one of the main reasons we’ve been so successful from an evolutionary point of view is because of cooperation and cooperation means that we work together. So being part of a group is incredibly powerful and being outside the group is incredibly dangerous.
So this is something that’s. deeply rooted in how our species has evolved over time. And so that, that is a, you know, the, the ability to, to stand outside the group is actually something that’s quite difficult to do, uh, just from a fundamental evolutionary point of view.”
He highlights research to show that non-conformance requires us to overcome neurological barriers in our brain. He suggests Seth Klarman’s view of value investing as a practical way of developing contrarian thinking in investing.
“Klarman says value investing, which is really all good investing, value investing is at its core the marriage of a contrarian streak and a calculator, right?
So the contrarian streak says we want to examine the other side of the issue. If everybody’s bullish, we want to see the bearish case. Everybody’s bearish. You want to see the bull’s case. But of course, being a contrarian for the sake of being a contrarian is not a good idea. Because the consensus is often right.
So, if the movie house is on fire, by all means, run out the door. Don’t run in the door, right? So this is the first thing, just to think about that. And then the second component is the calculator. And the calculator says, because everybody’s so excited, or because everybody’s so distraught, the asset prices become unduly expensive or cheap.
And the combination of those two things, I think, is where the magic lies.”
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