Financial Folly, Religious Frenzy and the Delusions of Crowds

What do financial folly and religious frenzy have in common? This question has not been carefully explored since Charles Mackay’s spectacular 1852 study, Extraordinary Popular Delusions and the Madness of Crowds.1

But, in a recent book, William Bernstein, a well-known economic historian, neurologist, and investment manager, makes the connection even more strongly than Mackay. The title of his book, The Delusions of Crowds, explicitly pays homage to Mackay’s classic. Bernstein’s delightfully written book is as worthy a read as Mackay’s.

Why investors should care about irrational behavior

Investors should be keenly interested in irrationality – in all aspects of it. Classic finance theory assumes that people are hyperrational, selecting portfolios that are mathematically optimal in their balancing of risk, return, and correlation. From all possible optimal portfolios, they select the one that most closely maximizes their utility, considering their aversion to risk.2 No one believes this, but the mistakes of millions of investors should cancel out, so that by analyzing markets as if people were rational, you should get a good approximation of reality.

Except when you don’t.

Financial markets burgeon with bubbles, crashes, high-priced stocks of companies with no earnings or revenues, and investors who act against their own interest. The recent headlines about GameStop, Bitcoin, Ark Invest, and the use of highly leveraged options by individual investors are reminiscent of the stories told by Mackay and Bernstein. To understand markets, it’s vitally important to figure out what’s going on when prices depart – in either direction – from fundamental value by large amounts.


Semper Augustus tulip

And I’m not just talking about the stock market. Government bonds are priced in classic Mackay fashion – discounting the hereafter.3 An Austrian government bond maturing in June 2120, almost 100 years from now, recently sold at a yield of 0.45%. Traders aptly call it the Semper Augustus bond in reference to a beautiful tulip involved in the Dutch tulip mania of 400 years ago.4 A Semper Augustus tulip bulb briefly cost as much as a house.

Religious frenzies and financial manias

It is timely to look not just at extreme behavior in financial markets but in other spheres of human activity. Bernstein’s choice of religion as the comparable sphere is understandable, although I quarrel with some of the logic and tone. In particular, religion at its worst can be unbelievably destructive: The Thirty Years’ War between Catholics and Protestants in 17th century Europe cost that continent about 20% of its population. Germany lost at least one-third of its citizens. In contrast, financial panics (the usual result of manias) almost always end in recovery and opportunity for investors. While I don’t mean to trivialize losing one’s money, there is a qualitative difference between that and losing one’s life.