One of John Templeton’s favorite books was Extraordinary Popular Delusions and the Madness of Crowds, written in 1841. He remarks that Charles Mackay’s book can teach us “some important lessons that apply to investor behavior today.”
In 1989, Templeton penned a new foreword for the book, applying its lessons to today’s investment world:
Although he wrote in the 1840s about public fiascos that are now distant history, Charles Mackay teaches us some important lessons that apply to investor behavior today. Basing our investment decisions on the actions of the crowd can be a disastrous gamble. And in this case, the “crowd” may well include money managers and analysts well-schooled in investment theory, just as it does the amateur investor.
Today, as in the time of the South Sea Bubble, human nature is drawn like a moth to flame by the speculative fads of the marketplace. The excitement of new glamour issues in electronics or medical technology, the general euphoria over a rising market; these lure even many experienced investors. Their optimism overcomes their better judgment. They abandon critical analysis of the investment’s fundamental value. Like gamblers in a casino they play against the odds, paying inflated prices and dreaming of quick profit.
A contemporary social psychologist uses the term “groupthink” to describe the modern manifestation of crowd madness. Groupthink represents the prevailing beliefs and rationalizations that all too often influence the decisions even of experts. Their investment advice is shaped by the opinions of others, not by the rigors of their own independent analysis.
Since then, the phenomenon has captured the attention of both students of economics and social scientists. Why, they ask in their books and articles, do trained money managers continue to be burned by faulty investment decisions? Ironically enough, they find the same powerful forces at work amid the sophistication of the financial community that Charles Mackay carefully chronicled nearly 150 years ago.
My own philosophy has long been that any individual with God-given intelligence, independence of mind, and patience can avoid the mistakes made by many of those experts who are swayed by the emotions of the crowd. I have always maintained that the best buying opportunities come at what appears to be the worst times. This applies to the general market and to particular securities. I have often sought out investments that performed poorly in the past, because research showed the phenomenon to be temporary. Usually these securities are out of favor with the investment community, so they are selling for less than their true worth. These may be any type of security, in any industry, in any part of the world. To find such securities and reap their worth, the investor’s first and last touchstone must be value.
Successful investing is only common sense. You should resist the temptation to invest in any asset which would have produced the best performance for the previous five years. Instead search worldwide for some type of assets which would have produced the worst performance for the past five years and then select from that list those whose depressed prices were caused not by permanent but by temporary influences.
The popular delusions and madness of crowds described in this book in 1840 have continued to occur in the 20th Century. A few examples during my lifetime have been as follows:
1. In the great Florida land boom of the early 1920s prices of vacant acreage in South Florida increased more than ten-fold and then collapsed within one year almost to the starting point.
2. The great American stock market boom ending in September 1929 caused share prices to increase six-fold and then collapse in less than three years to a point lower than the beginning.
3. In the 1950s, any stock concerned with uranium became exceedingly popular, often rising more than ten-fold and then later declining more than 90%.
4. In the gold bug boom of 1981 the price of an ounce of gold increased $35 to $875 and then declined more than 60%.
5. When the wild speculation in Kuwait stocks not listed on the Kuwait Exchange collapsed in August 1982, many had been bought for later delivery with more than $94 (U.S.) billion in checks post-dated as much as six months. Some 6,000 dealers failed to honor close to 29,000 checks, many of which were later found to be worthless. This amount is a larger figure than the total market value of all stocks on any European exchange at that time, except London.
In the 20th Century alone, more than a hundred other samples of popular delusions can be found among different varieties of assets in different nations. Excesses of crowd emotions occur not only in greed but also in fear.
This human failing can be avoided by an investor in common stocks if he will first investigate the cash dividend yield and market price in comparison with the previous prices for the same stock; the present price in relation to: the sales volume per share, the net asset value per share, the latest earnings per share, the average earnings per share for the latest five years, an estimate by a security analyst for earnings per share per year in the future, and the past and probably future annual growth rate of earning per share. Also beware of any type of asset bought mostly with borrowed money because such debt can lead to forced liquidation at distress prices.
It takes patience, discipline and courage to follow the “contrarian” route to investment success: to buy when others are despondently selling and to sell when others arc avidly buying. However, based on halt a century of experience, I can attest to the rewards at the end of the journey. The best way for an investor to avoid popular delusions is to focus not on outlook but on value.
John M. Templeton, 1989