Sunday, December 21, 2008

Extraordinary Popular Delusions and the Madness of Crowds

Marshall Goldsmith, a regular columnist in Businessweek referred to an interesting book entitled, Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay,. It is an ancient book originally published in 1841 (a greatly expanded version was published in 1852).

Goldsmith highly recommends the 1841 version of this book. Mackay, it seems, was a journalist. His writing was descriptive without being analytical. His reporting on what happened then is almost frightening when read in the context of what is happening now. He described three different "bubbles" from their inceptions to their peaks to their demise: 1) the "Mississippi Scheme," which swept France in 1720; 2) the "South Sea Bubble," which swept England in 1720; and 3) "Tulip Mania," which swept Holland in the 1630s. .

While Mackay didn't go into detail about the common elements that caused these popular delusions, Goldsmith was generous enough to share some reflections on what he learnt from this book that apply to what has happened in the past couple of years.

You may be in a bubble when:

• Everyone starts talking about their investments. In the manias described by Mackay, the popular press and day-to-day dialogue began to revolve around investment opportunities. In a similar manner, during the high-tech bubble, many nonexperts were quoting the price of Cisco or Sun Microsystems, and during the real estate bubble, many home owners were quoting how much houses down the street were selling for.

• Investment decisions are made solely on "how much this has gone up in the past," not "what is this worth?" In historic bubbles, popular dialogue was reinforced by charts that were dramatically moving up. Unfortunately, investors extrapolate from the past to the future. The South Sea charts in early England looked a lot like the stock charts we saw in early 2007.

• Some people do make a fortune. One high-tech "genius" Goldsmith knew made hundreds of millions of dollars selling a faddish concept in the peak of the bubble that (today) is worth next to nothing. While he did make a fortune, the investors that bought his company lost a fortune. In the same way, some tulip investors in Holland were smart enough to get out on top and made a mint. Plenty didn't.

• Greed overcomes fear. When investors focus exclusively on the upside and begin to ignore the downside, prudent risk assessment stops. Bundles of tulips in Holland made millions for dealers, until investors learned of their true risk. Bundles of "safe" home mortgages made millions for banks, until investors learned of their true risk.

Salespeople are disconnected from the true value of what they are selling. In old England, "stock jobbers" were peddling shares in companies that were about to disappear. Their commissions were completely disconnected from the long-term return on what they were selling. In modern America, "mortgage specialists" were peddling mortgages on houses that were about to dive in value. Their commissions were completely disconnected from the long-term return on what they were selling.

• Investors are overleveraged. In the same way that frenzied citizens of Paris borrowed whatever they could to invest in the Mississippi Scheme, frenzied investment bankers in New York borrowed whatever they could to invest in bundles of home mortgages.

• The investment is seen as a once-in-a-lifetime opportunity. When anything is given once-in-a-lifetime status, historical comparisons are discarded, because this is a different time. After reading Mackay, Goldsmith wrote that he was convinced that investors should spend more time reading thoughtful history books and less time listening to frantic stockpickers on TV.

Some of the connections Goldsmith made between these historical manias and today's bubbles are:

• If your neighbors are all talking about how much something is going up, it probably won't go up much longer.

• Never make linear projections from the past to the future. No one in the "hip" late 1960s would have projected that Ronald Reagan would become President in the 1980s.

• Someone will get in on the ground floor and make a fortune. That someone will probably not be you.

• Don't get too greedy. If it looks too good to be true, it probably is too good to be true.

• Before buying anything from a salesperson, understand how their commission is structured.

• When we become overleveraged, it is only a matter of time before our fantastic returns turn into dramatic declines.

• While the world changes, people don't. The same craziness that occurred more than 100 years ago in France, England, and Holland has occurred this year in America. Don't ever believe that we humans have become too sophisticated to fall into the same old traps.

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