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When safety in numbers does not add up

It can be all too easy to get caught up in market euphoria when making investment decisions. When people all around seem to be making money by investing in a particular stock or commodity it is difficult to argue against this apparent collective wisdom.

However, the advice of James Surowiecki in his ground-breaking book “The Wisdom of Crowds”, published in 2004, should always be considered in these circumstances: “Diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise.”

Similarly, the great Warren Buffett’s guidance to "Be fearful when others are greedy, and be greedy when others are fearful” should be taken into account.

Tulip Mania

The financial markets can be just as prone to fads and crazes as the fashion scene and the pop charts. This year’s “next big thing” quickly turns into “last year’s model.”

Perhaps the first recorded instance of the herd instinct taking over a market was the tulip bulb craze in The Netherlands between 1634 and 1637. It might seem hard to believe or even laughable now but Dutch people actually traded houses and farms for single tulip bulbs at the height of this mania.

It arose because the bulbs, which had only recently been introduced from Turkey, had contracted a fairly beneficial virus which affected their colouring in interesting and unusual ways. This made an already scarce commodity even more valuable. When the market eventually and inevitably crashed some people were left holding bulbs for which there were no buyers while they no longer had a house to live in.

From bubble to bust

Every time a bubble like this inflates and bursts there is a sense that it can never happen again because people will have learned from the experience. Sadly, history has shown otherwise. Most recently, the US residential property bubble which inflated during the early part of this century led to a global credit crisis.

Before that we had the dotcom bust of 2000 to 2002. This was the result of irrational investor euphoria surrounding just about any company which was based in any way on internet technology. Companies which had never made a profit and weren’t able to say when they might make one were floating on stock exchanges with extraordinary valuations.

The gloss came off quite rapidly as more and more of these companies reported mounting losses with many of them actually going bust within months of their stock market debuts. Warren Buffet had come in for quite a bit of flak for his outright refusal to invest in dotcom stock during 1998 and 1999 but he had the last laugh in a letter to Berkshire Hathaway shareholders in 2001 where he spoke of how the exceptional returns achieved during those years had lulled technology investors into complacency.

"After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities will eventually bring on pumpkins and mice."

Choose your own way

All this suggests that when the crowd is going in one direction it might be worthwhile to take a leaf out of the late Joseph Kennedy’s book. The legendary story has it that the Kennedy dynasty founder managed to emerge largely unscathed from the Wall Street Crash of 1929 as a result of an encounter with a shoeshine boy outside the stock exchange the previous year.

The boy gave Kennedy a stock tip and that gave him pause for thought. He is said to have told people later that he sold off his stock market positions very quickly after that: “You know it is time to sell when shoeshine boys start giving you stock tips. This bull market is over.”