The Wisdom and Madness of Crowds, and of Financial Markets
When thinking about the state of the market, I’m reminded of two phrases that seem contradictory, but accurately describe aspects of a crowd. The first is “the wisdom of crowds,” a well-known concept that highlights the collective knowledge of the many and its overall advantage over the collective knowledge of the few, even if the few are quite intelligent. When an individual does not know how to solve a problem, it is almost assured that at least a few people within a large group will have an answer. This was apparent in the 20th century when the knowledge from markets consisting of billions of people solved many more problems than did the knowledge from central planning committees made up of relatively few people.
The second phrase that comes to mind is “the madness of crowds,” made popular by Charles Mackay’s book, “Extraordinary Popular Delusions and the Madness of Crowds.” While crowds have a large pool of knowledge, they can also turn into a mob, becoming irrational or obsessive. We have seen this repeatedly during the last century in fanatical movements and market bubbles.
In markets, Benjamin Graham captured these two competing aspects of crowds when he said, “In the short term, the market is a voting machine, but in the long term, it is a weighing machine.” In the short term, the market votes and communicates (through prices) its current sentiment and best guess as to what the future will bring. Graham anthropomorphized this short-term sentiment and pricing as “Mr. Market,” who is often level-headed but sometimes becomes manic—overly optimistic or pessimistic. Over time, however, the true value of assets becomes clearer and is more accurately weighed by markets.
Mr. Market can become quite sure of himself, as he was when he assumed China would become the world’s largest economy. Chinese markets doubled in the five years from 2016-2020. But then, when it became clear that China had demographic and economic problems, the market erased nearly all those gains from 2021-2024. The same thing happened to markets in the U.S. for the three years prior to and after the dot-com bubble once it became clear that certain companies had become severely overpriced.
This isn’t to say that the market is constantly manic and making mistakes. There is much information in prices, and markets tend to improve outcomes and solve problems over time. A market is a very useful tool for us as citizens and as investors. The cost of this tool, however, is that we have to deal with constant noise, much of it nonsense, as well as Mr. Market’s moods. We believe investors are better off making decisions that conform to their planning based on discipline and diversification while blocking out the noise and the mania of the moment.
If you have any questions about market behavior and what it means for your portfolio, please reach out to us. What are your thoughts on the dynamics of market wisdom and madness?
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. Please consult your investment professional regarding your unique situation.