When to Bet Against the Crowd

Are you making your own decisions or just going along with the crowd?  The answer might suprise you.

Collective wisdom is entering a golden age.  Opinions are aggregated though search engines, social media and croudsourcing initiatives.  New “creativity” is sought through conformity.

There is something seriously wrong here.  Often, crowds can lead us astray and, as we have seen in the recent financial crises, you often follow them at your peril.  So the operative question is, when should you bet against the crowd?

Irrational Exuberance

In March 2000, at the height of the dot-com boom, professor Robert Shiller of Yale published his book, Irrational Exuberance, in which he predicted that the stock market had nowhere to go but down.  He was, of course, going against the crowd.  The Time Warner- AOL merger had just concluded and everyone was betting on the “new economy.”

Of course, within months the stock market crashed and  Shiller was hailed as a prophet.  Where did he get his divine insight from?  Well, there was no magic involved.  His reasoning was clear and transparent; as he showed in this graph:

Looking back, it should have been obvious that something was gravely wrong.  Prices (in red) had become completely disconnected from earnings (in blue).  Investors had no rational reason to expect a return, but the crowd was still piling in, assured that they were going to make a killing.

When he published a new edition in 2005 and included a chapter on home prices, there should have been some concern.  Once again, he asserted that prices had no basis in value and once again he included a chart graphically illustrating the problem:

Incredibly, the housing bubble went on for another few years before it crashed.  The crowd was in a mad rush to buy, flip and refinance because they thought they couldn’t lose.  After all, everybody said so…

Soros and Reflexivity

George Soros has made billions betting against the crowd.  He has even written and spoken extensively about how he does it.  Like Shiller, he has a fairly straightforward method that is easy to follow.  There is no artifice, mysticism or sleight of hand.

He calls his method reflexivity and it relies on the stupidity of crowds.  He posits that trouble begins with true value.  Some people start making money and everyone else rushes in, increasing asset values further.  Of course this only feeds the fire, and prices continue to rise just because everybody thinks they will.

Of course, it never lasts.  Facts are stubborn things and no amount of new economy or greater fool explanations will stave off the inevitable result.  Markets crash, millions of people lose billions of dollars and a few smart cookies like Soros earn a bundle.

Media and Marketing Crowds

Media and marketing crowds tend to be more foolish than most.  A community that prides itself on new ideas is bound to be susceptible to the fantasies of false gurus.  Listening to an exciting vision is certainly more interesting than going through mountains of data.  A small core of believers can provide an echo chamber from which the idea can virally spread to a more general audience.

In the past, I’ve taken great pains to point out when the rhetoric doesn’t match the facts.  Back in January 2010, I wrote that magazines would make a comeback simply because there wasn’t anything intrinsically wrong with the industry.  Low and behold, publishers revenues are far outpacing the economic recovery.

More recently, I wrote about why traditional media companies are flourishing and got a surprising amount of feedback either denying it was true or insisting the recovery to be short lived.  On the AdContrarian blog, Bob Hoffman listed 10 pretty straightforward facts and was rewarded with an avalanche of vitriol.

It seems that many people prefer popular lies to lonely truths.

Influence and Local Majorities

At this point, it makes sense to ask the question, why are people so susceptible to false beliefs?

Solomon Asch documented the phenomenon in the 1950’s with his conformity experiments.  The concept was simple, but ingenious.  He showed people the two charts below and asked which of the lines on the right was the same length as the one on the left.

However, there was a twist.  Only one person in the room was a real research subject.  The rest were confederates who all knowingly gave the wrong answer.  Amazingly, when confronted by a false majority, 75% of the test subjects gave wrong answers.

Further research was done more recently by Nicholas A. Christakis and James Fowler and summarized in their book Connected.  What they found was even more startling: not only are we influenced by close connections, but are affected by people 3 degrees of separation away.  So even the views of the friends of our friend’s friends contribute to our world view.

Our thoughts are truly not our own, no matter how much we would like them to be.

What Do You Think You Know and Why Do You Think You Know It?

The truth is that we don’t put much effort into forming our opinions.  Most of our information we pick up either completely passively or at least without much reflection.  We go along with the crowd much more often than most of us would like to admit.

However, what is surprising is the extent to which crowds affect our thinking on issues that are not only substantive, but for which we are professionally responsible.

From highly paid investment professionals who got taken in by Bernie Madoff to marketing professionals who try to be trendy by proclaiming that it’s “all about the conversation,” the rabble and specious reasoning often prevails.

The only remedy is to accept that you are as likely to be taken in as anyone else and, on any issue of import, start with questions rather than answers.  Re-examine your assumptions as much as you can.  Chances are, you really don’t know where they came from.  That’s the only way you can confront conjecture with facts.

And when the facts defy the crowd, bet against it.

– Greg