Piet Viljoen: Are investment crowds wise or mad, or perhaps both?

Value investor Piet Viljoen, founder of Re:CM, reconciles two seemingly contradictory ideas: the "wisdom of crowds" underlying index investing and the "madness of crowds" behind market bubbles. Prompted by an MBA student's question at GIBS, he draws on Charles Mackay's 1841 study of historical manias (emotions like greed and fear driving collective irrationality) and Michael Mauboussin's thesis that crowds are wise only when opinions are diverse, aggregation is independent, and incentives are sound. Viljoen concludes both concepts are true depending on conditions. His rule of thumb: index efficient markets, but seek active management where diversity has broken down..By Piet Viljoen*.The French Revolution is widely regarded by sociologists as a quintessential example of crowd psychology and mass hysteria. It demonstrated how ordinary individuals can succumb to extreme, uncharacteristic violence and irrationality when swept up in collective fervour.But there is also a large body of work that purports to show that crowds are generally quite smart. In fact, it’s the reason why active managers find it so hard to outperform the index.This contradiction was brought home to me once again a few weeks ago when I gave a guest lecture at the GIBS (Gordon Institute of Business Science). I really look forward to these sessions; interacting with the students is a pleasure. What makes it such a pleasure is that the interaction is a two-way street. I not only give a lecture, but also get to spend at least 45 minutes answering their questions.These are not undergraduate students there because they have to be, with no exposure to how life really works. No, these are MBA students, all with real-world jobs and experience. They're probably paying for the course out of their own pockets.By and large, the questions are good ones that force me to think on my feet.Last month, at one of these sessions, I was asked to reconcile the concepts of "the wisdom of crowds" and "the madness of crowds". As a proponent of indexation, I firmly believe in the wisdom of crowds. But as a value investor at heart, I also recognise the madness of crowds.One of the students asked how to reconcile these beliefs, which seem to contradict each other fundamentally. The question was so obvious that it caught me completely off guard. My rambling answer was something along the lines of "Crowds often behave poorly, which explains why the madness of crowds is such a well-entrenched concept. But you, as an individual, can behave differently, enabling the crowd to be wise".Or some such drivel. And it bothered me, because I knew my answer was wrong.Let’s use some examples to set up the arguments properly, to see why both concepts are correct, and don't contradict each other. Starting with a quote by Charles Mackay, from his book "Popular Delusions and the Madness of Crowds", first published in 1841.Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.He wrote the book to present his historical study of economic bubbles, scams, and mass hysterias. It explored famous historical events in which collective judgement failed. Mackay examined manias, ranging from financial bubbles (such as Tulipmania) to social delusions (such as witch-hunts and alchemy). He showed that these are not isolated events, but recurring patterns in human history.Mackay concluded that emotions drive crowds to behave abnormally. Emotions such as greed, fear, and the desire for excitement can act as catalysts. Sound familiar? Those are exactly the emotions that have driven wild price gyrations in stock markets since time immemorial, or at least since the early 1800s.Then, we had Mauboussin. In his article, "The Wisdom of Crowds", he posited that market efficiency arises from the aggregation of diverse, independent, and often irrational individual views, where uncorrelated errors cancel out. He argued that you needed three conditions for crowds to be "wise":.A diversity of opinion, i.e., heterogeneous points of view.An independent aggregation mechanism - a way of bringing information together.The existence of healthy incentives - proper rewards for being right or wrong.Mauboussin concludes that market failures and bubbles arise not from a lack of intelligence, but from a loss of diversity that leads to correlated behaviour and information cascades.The upshot of the work of these two men is that crowds can be either wise or mad - it depends on the circumstances. So, the rule of thumb (for me) remains - index where markets are reasonably efficient and only seek out active management in those pockets where diversity has broken down..*Piet Viljoen is the founder of Re:CM and will retain his 100% attendance record by delivering a keynote address (and more) at BNC#9. To subscribe to his weekly newsletter - from which this piece is drawn - click here. .Sign up for your early morning brew of the BizNews Insider to keep you up to speed with the content that matters. Register here.Support South Africa’s bastion of independent journalism, offering balanced insights on investments, business, and the political economy, by joining BizNews Premium. Register here.If you prefer WhatsApp for updates, sign up to the BizNews channel here.

Piet Viljoen: Are investment crowds wise or mad, or perhaps both?

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