Crowd Mentality Theory

"Even the intelligent investor is likely to need considerable willpower to keep from following the crowd." - Benjamin Graham

Crowd mentality is the behavior and actions of people in groups. The base tenet of this theory is that the actions of a person will differ when he is among a bunch of people (crowd) compared to when he is acting in isolation. A crowd can be often driven toward irrational actions that most isolated individuals would not attempt.

How is this applied to Financial Markets? Well, open the at below image and observe it for some time.

Extreme optimism signals when the bull market is about to end. Greed makes people think that the markets go only north and there are no limits. Smart investors find this opportunity to sell off their stock and sit on cash. The opposite of this could be seen at market bottoms with prevailing extreme desperation.

What does this have to do with Crowd behaviours? Simple, the crowd happens to be the best medium to spread greed and fear, the emotions playing at the market tops and bottoms respectively!

So, how do we identify crowd mentality and act in our favor? Its not an unheard saying - Act exactly opposite of crowd: Buy when every one is screaming to sell and sell when every one is busy buying. But, if it is all that simple, we all would be millionaires, wouldn’t we? :)

After all this mumbo-jumbo on the theory, the question every one must have: Is the crowd behavior always irrational? Not necessarily! This is the main flaw in the theory. Some key points to keep in mind, however:

• Crowd mentality theory is to be primarily applied in medium to long term investing, not in day-to-day trading.
• This has to be applied in conjunction with other disciplines, be it technical or fundamental analysis.
• When every one is screaming to sell or buy, ask yourself, is this rational? For example, many CNBC analysts said the market was overvalued when sensex was at 16000 in 2007 and the same analysts were finding the market very attractive and undervalued when sensex was at 16000 2008. Is this rational? What has fundamentally changed in 1 year? Probably nothing.

Happy trading!