The Stuff of the Madding Crowd

Dear Reader,

I like to think of these Whiskey essays as my half of a casual, but spirited conversation — over drinks at the Vancouver Fairmont, perhaps, or the Lone Eagle Grille on Tahoe’s North Shore.

Picture it: We are comfortably ensconced in leather-backed chairs — you with your favorite beverage, me with a Maker’s Mark on the rocks — as a skilled piano player works quiet magic in the background.

An attentive hostess refreshes our drinks. I lean forward in absent-minded enthusiasm, only mildly distracted by some random new insight from the ether.

“So where were we…we started off with Punctuated Bubbleibrium, correct?”

“Yes. And then you were going to talk about break points and inflection points. But you took an unexpected side road intothe value of latticework.

“Right! Break points and inflection points. Fascinating stuff. Critical for grokking how markets really work. But wait a minute…have we talked about cognitive biases and the ways of the madding crowd? About the psychological and sociobiological underpinnings that facilitate the existence of break points and inflection points in the first place?”

“Nope…don’t think we’ve hit on that.”

“Well, that’s no good. Can’t leave that out. It just wouldn’t sit right. I suppose it’s off on another rabbit trail, then.”

Three cheers for rabbit trails!

I’ve come to realize that my unspoken mission here — creating a 360-degree market tapestry of sorts, in which I pour forth the constellation of ideas in my head — doesn’t lend itself well to a lot of meticulous planning. The process thus far seems to be:

  1. Conceive desirable topic N.
  2. Prematurely announce intentions to write about N.
  3. Delve into N; realize that unexpected prelude X is more appropriate.
  4. Write about X instead; conceive new N in conjunction with X.
  5. Repeat Step 1.

Your humble latticework correspondent is hardheaded, but persistent…and, being a touch stubborn himself, knows a stubborn pattern when he runs across one. Thus, like the fate of Schrodinger’s cat, our projected order of Whiskey topics shall henceforth be a matter of deterministic uncertainty.

Getting back to business (if one can call it that): Before we meander ’round to break points and inflection points — one of these days — let’s reflect on the psychological underpinnings of the madding crowd.

“Social and cognitive psychologists have identified a number of predictable errors (psychologists call them biases) in the ways that humans judge situations and evaluate risks. Biases have been documented both in the laboratory and in the real world…”
— Nobel laureate Daniel Kahneman

“I shouted out, ‘Who killed the Kennedys?’ when after all, it was you and me…”
— The Rolling Stones

An impossible creature who never existed, “rational economic man,” is an egghead yeti of sorts — an abominable snowman of lost legend, roaming the stuffy halls of academia.

Like his furry Himalayan counterpart, rational economic man has been thoroughly exposed as a hoax; only a few cantankerous die-hards remain snowed by him. (Snowman…snowed…get it? Rimshot, cymbal crash, groan.) The great debunking was due, in large part, to the work of noted psychologists Daniel Kahneman and Amos Tversky. In the late 1970s, Kahneman and Tversky developed something they called “prospect theory” — which, confusingly, had little to do with prospecting and everything to do with human behavior.

Kahneman and Tversky’s prospect theory was, at long last, a real-world answer to the hopelessly sterile “utility theory” of neoclassical economics. Based on observed human behavior, rather than abstract blackboard calculations, prospect theory laid the groundwork for the discipline of behavioral economics — and was thus a big nail in the coffin for Homo economicus rationalis.

In recognition of his groundbreaking work, Kahneman won the Nobel Memorial Prize in Economics in 2002. (Tversky, sadly, had passed on by that time, and prizes are never awarded posthumously.) In the past few years, behavioral economics has developed a bit of pop culture cachet, catching nods in hastily written articles and books.

As a result of this, cognitive biases are practically old hat as a topic of discussion in some circles — you can, in fact, find a very nice list of them on Wikipedia. Yet though cognitive biases have duly made the rounds as cocktail party chatter, few have really pondered their influence on the crowd…and, by way of extension, the crowd’s inevitable influence on how markets work.

To better grasp the nature of the multiheaded beast called “the crowd,” let us begin with the first-person biases inherent in you and me. After all, we have all given way to the crowd from time to time…and as Walt Kelly’s Pogo once said, “We have met the enemy and he is us.”

John Maynard Keynes had an early bead on this topic, stating that “Practical men…are usually the slaves of some defunct economist.” But the situation is far more deep-rooted than Keynes could have suspected. The average man, practical or not, is actually a slave to his genetic wiring.

We were born, you see, with all kinds of biases hard-wired into our hearts and minds. These biases are not so much “errors” as quirks in the program. Man’s existing genetic blueprint developed by trial and error over millions of years and, like a durable but slightly outdated piece of software, the version in place today is still optimized to hunter-gatherer parameters. Thanks to strong cultural overlays and the inherent plasticity of the brain, the old operating system has been significantly modified — but the ancient kernel still remains.

It is very hard, if not impossible, to pinpoint where genetics ends and culture begins. In many ways, they are two sides of the same coin. Cultural examples of genetic hard-wiring abound in nature; consider that monkeys have an inborn sense of fairness, as reported by The Wall Street Journal:

“Even when little or no effort is required, chimps and capuchins balk at unfair situations, says anthropologist Sarah Brosnan of Emory University. In a series of experiments, the animals learned to trade a ‘token’ (a rock or plastic pipe) with a trainer for food. If they saw a cagemate trade for a delectable grape, but were offered a cucumber in exchange for their own token, they were much more likely to refuse to hand it over for the stupid vegetable. Better to go hungry than to give in to this unfairness.”

Do societal rules shape natural behavior or do the exigencies of natural behavior shape society itself? It’s really a chicken-and-egg question. Even the lesser animals routinely engage in bluff, bluster, and deceit when self-interest demands it. The New York Times reports:

“Male stomatopods dig burrows, to which they try to attract females. Some males choose to try to evict other stomatopods from their burrows and take them over. These conflicts are dangerous because stomatopods can deliver crushing blows with their claw-like appendages. But the stomatopods rarely come to blows. Instead, males raise themselves up and extend their appendages, like a boxer raising his gloves. The sight of big appendages causes smaller stomatopods to back down.

“Yet even the biggest, meanest stomatopod has his moments of weakness. Like all crustaceans, they must molt. A freshly molted stomatopod has a soft, tender exoskeleton. Even in this vulnerable state, however, males will still raise up their claws in a bold crustacean bluff.”

Most fascinating of all, in your editor’s humble opinion, is the evidence that hard-wired genetic behavior can lead to distinct situation-specific responses. Consider this passage from E.O. Wilson’s Consilience:

“When vervets and other guenons, common long-tailed arboreal monkeys of Africa, encounter certain kinds of snakes, they emit a unique chattering call. They are evidently good instinctive herpetologists, because the response, which appears to be inborn, is limited to the poisonous cobras, mambas, and puff adders. The response is not made to harmless snakes. Others of the monkey group come to the side of the caller, and together they watch the intruder until it leaves the neighborhood. They are also ready with an inborn eagle call, causing all the troop members to scramble down from the trees and out of danger, and an inborn leopard call, triggering a rush in the opposite direction to parts of the canopy that big cats cannot reach.”

The point here is that, by way of natural analogy, man has his own set of factory-installed predilections and reactions — some of them helpful in this day and age, some decidedly not. We rage at unfairness like capuchins; we bluff and bluster like stomatopods when self-interest calls for it; and we have a set of tailor-made responses to various situations, like the long-tailed monkeys of Africa. (This particular rabbit hole goes even deeper, but we will leave off exploring it for now.)

In addition to genetic wiring, humans are deeply influenced by their elders and peers through the influence of external culture. From an early age, we are all shaped by the cultural and moral reinforcements that shore up functional society. Human children are born with a natural disposition to believe their parents and take in vast amounts of information on faith, to ensure that the societally beneficial “culture transfer” continues from one generation to the next.

In his excellent book Influence: The Psychology of Persuasion, Robert Cialdini demonstrates how our genetic and cultural hard-wiring can be used against us. In a nutshell, unscrupulous practitioners can take advantage of our programming by exploiting the soft underbelly of general-purpose patterns we all rely on.

Because life is so complicated, humans tend to navigate by rules of thumb — or heuristics — without realizing it. We constantly rely on shortcuts and approximations to manage the endless flows of information and choice we are battered with each day; as a result, certain rules of thumb can be so deep-seated we completely forget they are there. It’s a bit like engaging the autopilot — except the decision to go autopilot is itself a result of autopilot!

Under cover of subliminal darkness, the determined influencer can deliberately manipulate our autopilot rules — and thus manipulate us — in powerful ways. Cialdini sums up this state of affairs in noting that “Although… there are many situations in which human behavior does not work in a mechanical, tape-activated way, what is astonishing is how often it does.”

The rub is that Cialdini’s six “weapons of influence” — reciprocation, commitment and consistency, social proof, liking, authority, and scarcity — can be used for good or for ill with equal flair. The difference is often a matter of subjective opinion. For example, Wall Street and Madison Avenue are certainly not shy in employing these weapons of influence; but then again, neither are the various evangelists of the world’s popular movements and religions. Where you stand on such matters depends on where you sit.

Reflecting on all this, you hopefully now have an idea of what a poor state John Q. Public is in. He is a slave to his genetic wiring without even realizing it; his perception of the world is distorted six ways to Sunday by cognitive biases he doesn’t even know exists; if he does know they exist, he probably assumes himself “above average” and thus immune to them — a cognitive bias in itself; and last, but not least, he is constantly being pushed and pulled by benevolent and not-so-benevolent interests, all of them intent on using the “weapons of influence” to make him go a certain way.

Add the strong emotional tang of fear and greed to this mix and here you have the basic building block of crowd behavior. Get a few thousand or a few million John and Jane Q.’s together, stir them up with the right cocktail of influences, and there is practically no limit as to what you can get them to think, say, or do.

Aw, nuts. Here we are closing in on 2,000 words and we haven’t gotten to volatility, reflexivity, or the essentials of crowd behavior yet. What’s a guy gotta do to scratch a surface around here?

At least I have a strong bead on where we’ll be heading next…but in the spirit of lessons learned, I shan’t confirm for certain.

At any rate, I hope you’re enjoying the “conversation” thus far…which, barring my untimely demise, shall definitely continue.

Cerebrally yours,

January 23, 2007

The Daily Reckoning