On Markets

It is held that Gustave LeBon described the behavior of financial markets with the statement, “An intelligent man becomes a blockhead the moment he becomes a member of a crowd.” For me,
this statement says nothing about markets or their participants.

In The Crowd, Lebon’s famous work on mass psychology, the author described the behavior of men  joining crowds during emotionally charged events. The chapter on classification of crowds includes criminal crowds, criminal juries (lynch mobs), electoral crowds (revolutionary mobs), and parliamentary assemblies. There is no
reference to men in markets.

An organized auction market is not an event. It is a continuous opportunity flow. Its currency is information. The participants arrive and depart as individuals. They don’t join one another. Wittingly, or otherwise, they compete. They mostly fail to achieve  their objectives because they unwittingly misuse the currency. The chief obstacle to good use of information is uncertainty. Uncertainty is the defining
characteristic of markets.

Uncertainty acts on individuals at critical times during their participation in markets, causing them to respond in predictable, non-rational fashion. Success in markets comes to those who understand the pattern of these responses and act in a fashion that enables them to take advantage of the patterns, while adapting their own non-rational responses to the same environment of uncertainty. It is no small task and it is not well understood. That is why so few participants take more wealth out of the markets than they put in.

There are two types of participants: New Guys, and Experienced Investors. Every Experienced Investor was a New Guy once. New Guys arrive at the market armed with capital, rational strategies, forecasts, hopes and expectations. The moment they encounter uncertainty, they begin to act in self-sabotaging ways. Fear of uncertain outcomes keeps them out until the move is almost over. When they do get in early, fear gets them out as soon as the
early profit begins to erode in the first setback. Mostly, though, they wait until the market has moved up significantly, and then charge in, fearing the train will run off, leaving them stranded at the station.

New Guys are never happy. They regret they didn’t get in, or they regret they didn’t sell when they could have, or desperately hope they’ll get even someday. It’s a mess. The consequence of this is that New Guys act impulsively. When the regret gets to be too much,
they dive in so they won’t miss out. When the pain becomes intolerable, usually close to the bottom, they liquidate. These actions are hard-wired responses driven from the emotional side of the brain, the side that does not learn from experience. It happens over and over to the New Guys until they run out of capital or excuses.

New Guys are New Guys in behavior, not in time in the market. A mutual fund manager can be a New Guy throughout a 30 year career, so long as his sales force can replace liquidations by raising New Money. Generally, this is accomplished by flogging the mountain
chart of his results during the one bull market he was randomly present for.

New Guys are the market. It is counterintuitive, but the swings in the markets that provide money-making opportunities are caused by the impulsive behavior of New Guys.

Most New Guys leave the market forever at the conclusion of the bear market that follows the bull  market that sucked them in. A very few New Guys lick their wounds, ponder for a bit, and figure out that it is they, not the market that screwed up. When they come back, they observe their own non-rational behavior, which is as hard-wired as anyone else’s. Now they are in a position to adapt to uncertainty and to learn how to capture profits from the actions of the New Guys. Now they are making the transition towards becoming Experienced Investors.

Becoming an Experienced Investor is a most difficult undertaking. An Experienced Investor must invest, fail, and make use of that experience to succeed. Empiricist David Hume, not Le Bon, is the patron saint of Experienced Investors.

 The young man sought out the old man and asked,

“What do I need to make good
The old man said, “Wisdom.”
“How do I get wisdom?”
“How do I get experience?”
“Make bad decisions.”




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