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Mob Mentality Psychology And Crisis Investing

February 20, 2014 2 Comments

What is crisis investing?

Crisis investing involves employing a contrarian investing philosophy by seeking out temporary crises and panics that can naturally spark a mob mentality psychology in unweary stock market participants.

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What is mob mentality psychology?

Mob mentality psychology is also known as crowd psychology, or herd psychology and is a branch of social psychology that deals with the behavior of human beings in large groups.

This kind of discipline may appear to be a bit condescending to some people as it seems to be comparing the behavior of human beings with that of wild animals herding in nature. But we must not forget that humans are a part of nature, and that according to behavioral economics, we form crowds with distinct behavioral characteristics, just as other organisms do.

Mob mentality is caused in part by the concept of “social proof” which is the well-documented tendency of people to think (either consciously or unconsciously) that whatever behavior a number of other people are engaged in must be important and “right”, and that a group of people engaging in a particular activity must collectively know more than us about that activity. While this heuristic is often the case (i.e., the law of large numbers), and is therefore often times beneficial, it can also occasionally lead us astray.

Why are humans prone to social proof and herding behavior?

In terms of evolutionary psychology, if one of our ancestors wanted to know where to find the nearest watering hole on the African Savannah, the best thing that person could have done is ask or follow their fellow tribesmen who claim to know where a nearby watering hole is.

The best idea is certainly not to “go it alone” as the saying goes and wander off searching by yourself for a new source of water.

Individuals who “followed the herd” in this sense, and who naturally possessed stronger tendencies towards social proofing, would have had a much greater likelihood of surviving and passing on their genes. Individuals who disappeared onto the Savannah by themselves would have had a much greater likelihood of having their genes pruned from the gene pool.

The effects of this evolutionary hard-wiring (among other influences) are still present and affecting our behavior today.

Just think of the effect of a long line-up outside a restaurant. That line-up signals to hungry passersby that the restaurant is of high quality because so many people are willing to wait in line to eat there.

Here’s how Dan Ariely, professor of psychology and behavioral economics at Duke University, describes social proof:

The natural inclination is to see what other people are doing, and to try and follow other people.

Characteristics of panicked crowds

Regardless of what causes a mob mentality psychology to take hold during a crisis (though it’s an interesting topic in its own right that I explore more in this post on Reflexivity and Behavioral Finance, and in this post on the Psychology and Incentives of Institutional Investing), we can examine the patterns that panicked crowds display and attempt to profit off of them in the stock market.

Scientists have done experiments where they place test subjects directly in the center of a room with an exit door on either side (each an equal distance from the center). When scientists spark panic they find that a substantial majority of people will (irrationally) favor one of the exits over the other.

According to behavioral economics experts, here are some of the noted characteristics of panicked individuals in crowds:

  • Individuals attempt to move faster than normal
  • Interactions between individuals become physical
  • Exits become arched and clogged
  • Escape is slowed by fallen individuals serving as obstacles
  • Individuals display a tendency towards mass or copied behavior
  • Alternative or less used exits are overlooked
  • This list makes a great metaphor for the stock market during a financial panic. An emotionally charged herd on Wall Street will stampede in the exact same direction, headed for the same exit as quickly as possible to ensure that each sells before the other can, and in so doing clog up the gateway (capital markets).

    When this happens, it often becomes possible to find irrationally undervalued stocks relative to their longer-term outlook, which brings me to my next point.

    How to exploit mob mentality to profit from crisis investing

    We can apply these findings on the nature of panicked crowds to our investing by following 2 key steps:

    1. Be a contrarian: actively seek out “crisis situations” that could potentially spark investor herd psychology.

    To find these situations I highly suggest keeping up with current events happening in politics and economics from around the world.

    2. Extensively research the crisis to ensure that it is not likely to be permanent (or at least that the odds of it being permanent are clearly worth it based on the price:value discrepancy).

    In order to understand the multitude of twists and turns that can happen in the future I recommend familiarizing yourself with the extreme variations of history. A great resource for learning about some of the intensely irrational crowds of the past is the book Extraordinary Popular Delusions and The Madness of Crowds.

    Any impactful crisis rationally ought to cause some amount of fear, and provoke some amount of selling. But the idea behind crisis investing is that as the mob on Wall Street begin to press the sell button for legitimate reasons, it can create an environment where selling begets selling and share prices collapse. Not all the time – but a crisis is one of the best situations to hunt for stock market inefficiencies.

    An example of a natural crisis (no pun intended) is the recent extreme oversupply of natural gas in the US (caused by the revolution of hydraulic and horizontal fracking unleashing enormous quantities of previously untapped reserves) causing prices to plummet to unsustainably low levels of below $2/MCF where effectively the entire industry was losing money on a highly necessary, clean, abundant, domestic, and cheap fuel source.

    Basic supply and demand reasoning would suggest that this glut was a temporary problem that the market would take care of naturally: supply would decrease as natural gas companies shut in unprofitable wells and ceased to expand their operations, and demand would increase as the costs of this form of energy plummets. The result of these two factors would mean that over the long-term we should expect natural gas prices to normalize though at perhaps a slightly lower level.

    But these are the situations where the mob mentality says “x number of people have already been killed betting on natural gas” and “nobody knows how low the price could go”.

    They are also the situations for a careful contrarian investor to scour the market for an extremely undervalued fantastic company with an industry leading balance sheet, credit facility, and operating margins to ensure that they can survive the (temporary though possibly protracted) storm of depressed prices. As the old story goes: if you catch yourself in the woods with an angry bear in front of you, you don’t need to outrun the bear as long as you can outrun your friend standing next to you.

    Successful investing is often counter-intuitive, and is often contrarian investing. You don’t want to run to the company with the obviously great characteristics and future potential that will obviously be successful, because most of the time the market has already realized how great these stocks are and has bid up the share prices to extreme heights. This means that despite the fact that a particular company (such as Amazon for example) might be a fantastic business, at the current valuation it does not provide any margin of safety or downside protection.

    So where do you want to hunt for stocks? According to behavioral economics and findings from crowd psychology you want to search for the most hated, scuzziest, out-of-fashion stocks you can find and start looking through the garbage dump because that is where you will occasionally find undervalued gems.

    By being a contrarian and insulating your thoughts and emotions from the herd during a crisis you can invest in great companies at great prices. If you’re right about the crisis being temporary, and you are able to purchase great growth companies at bargain value prices, then you will likely experience the double satisfaction of expanding earnings and cash flows, as well as expanding multiples in the marketplace over time, and this makes for wonderful returns.

    Follow me on Twitter: @ContrarianVille

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