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Innovative Trading - Day Trading

The MMM Fiasco: A Russian South Sea Bubble

The company MMM has recently become Russia’s biggest share scandal and has been referred to as Russia’s South Sea Bubble.

The price of the stock rocketed as the company promised to pay up to 80% dividend on shares per month, or 960% annually! The promise, of course, was totally unsubstantiated by any explanation as to where the money would actually come from. The company reported no earnings, revealed no investments and explained no financial strategy. The price of shares reached 125,000 Roubles, around $60, from a mere few hundred Roubles. The price was purely driven by new people buying shares. The demise of the company started with the repeated warnings from the Government, including President Yeltsin, and raids by Government officials for tax violations. A scramble to sell ensued and the price dropped to 950 Roubles, around 60 cents.

Mr Mavrod, MMM’s charismatic Chairman, claimed that:

“We have been stopped on the eve of a super breakthrough after which Russia could have become the richest country in the world, and Russia’s MMM shareholders were wealthy people.”

How many people believed Mr. Mavrod’s empty rhetoric? The estimated figure of shareholders was disputed. Government estimates were 2.5 million, and MMM’s estimate 10 million. Whichever figure was correct, the amount of investors was considerably bigger than the Russian army and, just like the South Sea Bubble it has been compared to, investors came from all walks of life and included many Government officials.

Examples of emotionally generated trading are common throughout the twentieth century. We have the Florida land boom of the 1920s, the UK property market in the 1980s, the Silver speculators in 1980 and, of course, two major stock market crashes in 1929 and 1987. The two emotions that come to the forefront are greed and fear. A bull market starts in a climate of fear. As the market gradually makes headway, fear recedes and confidence appears as prices move higher. Finally, as prices reach a cyclical peak, euphoria and greed take over, and there is a consensus that the rise will continue indefinitely. On the way down the same emotions predominate, but in reverse order. The emotions of greed and fear are the ruin of the majority of investors.

“The crowd madnesses recur so frequently in human history that they must reflect some deeply routed trait of human nature...If this book showed how baseless are man’s moods of wild hope (greed), it also showed that man’s moods of black despair (fear) are equally unfounded. Always in the past, no matter how black the outlook, things got better...whenever men attempt they seem driven to try and overdo.” B. Pugh

IV. CONTRARY OPINION

“The fact that an opinion has been widely held is no evidence that it is not entirely absurd; indeed, in view of the silliness of the majority of mankind, a widespread belief is more likely to be foolish than sensible.” Bertrand Russell

So why does the crowd always get it wrong? The majority lose because most investors are followers, not leaders. Investors wait until they see other people buying, and they wait until they see other people selling. As a result, most people buy after prices have already risen and sell after prices have already fallen. By chasing the crowd, the typical investor loses twice over, he buys too high and sells too low.

When people get caught up in a crowd, they stop thinking rationally and allow themselves to be governed almost entirely by emotions. This state of mind prevails at almost all market tops and bottoms. During these moments of mass delusion, the crown extrapolates the current trend too far. As Humphrey Neil point out:

“A crowd never reasons but follows its emotions, it accepts without proof what is suggested or asserted.”

The long-term component of market prices becomes grossly, irrationally exaggerated. Ultimately economic reality takes hold and prices return to more realistic levels. In the interim, however, the lunatics have taken over the asylum.

Consider the following: investors buy because they expect the market to go up, and they sell because they expect the market to go down. However, if everyone in the market place is looking to go up (a consensus), the consensus that everyone who is going to buy has already bought, so who is left to bid prices up? The same obviously applies in a falling market. In a free market you will never get a 100% agreement, however, the closer it is to a consensus the more likely the majority is badly mistaken.

When a virtually unanimous, emotionally charged majority appears, it is almost certain to be wrong. An important point to remember is contrarians do not argue the majority is wrong. The majority is often right about long-term primary trends all contrarians argue is that the crowd suffers, mass delusions and extrapolates the trend too far. As Humphrey Neil says to the question “Is the public always wrong?”

“The answer is decidedly no. The public is right more times than not. In stock market parlance, the public is right during the trends and wrong at both ends.” It is at both ends we will use the theory of contrary opinion to enter the market for maximum profitability.

V. THE MADDING CROWD

In this chapter I want to dwell on human personality and why we end up following the crowd, and how our emotions affect us. It is quite clear from what has just been written that the bulk of investors need to change their behaviour. In order to change investor behaviour, we must observe how it develops and how we can change it.

If you consistently buy into fear and sell into greed, you will make money. It sounds incredibly easy. What has already been said will probably strike you as logical; however, in practice people find it incredibly difficult to do. We are all susceptible to the influence of the crowd. In fact, in normal, everyday life, being part of a crowd is seen as being totally normal. In 1890 Gustav Le Bon wrote a brilliant book that is essential for any investor to read “The Crowd, A Study of the Popular Mind”. In crowd psychology, a “crowd” has different characteristics from individuals. Individuality becomes lost, as it were, and a collective mind is formed. Le Bon states that a gathering that becomes an organised crowd “forms a single being and is subjected to the law of mental unity of crowds,” and a “crowd is at the mercy of external exciting causes and reflects their incessant variations. It is the slave of the impulses which it receives”. Le Bon is making an important point in that the mind of the crowd often reflects the behaviour of the lowest common denominator in the crowd. Therefore, crowds do not exhibit highly intelligent behaviour. The person then who is capable of individual thought has a tremendous advantage. As Humphrey Neil points out:

“A crowd never reasons, but follows its emotions; it accepts without proof what is suggested or asserted.”

A crowd basically exhibits the worst type of behaviour possible when investing, combining high emotion with little or no independent thought. We, however, on many occasions embrace the views of the crowd because it is quite normal within society.

Trading can be difficult and confusing because some of the character traits and impulses considered normal in society may tend to be the opposite of what is required in trading. This does not imply that trading is immoral or antisocial, but requires a different approach. In his book “Instincts of the herd in peace and war”, W. Trotter asserts that man is essentially a social animal; he is gregarious, which comes from the Latin word for flock. He is essentially intolerant of solicitude. He is more influenced by the herd that any other influences. He is subject to the passions of the pack, he is remarkably susceptible to leadership, and his relations with his fellows are dependent upon recognition of him as a member of the herd.

Many of our modern day responses can be traced back to prehistoric times. Our security and existence was dependent upon binding together in groups. This coming together of groups is therefore natural to the human race. The structure of society again reinforces this. Most societies have rules and laws within their structure that people are taught to obey. Man’s natural sociable nature and fear of loneliness or isolation also make him seek the company of others; the family unit being an obvious example. You may say that in Western society we have free thought. We do in certain areas, but there is still considerable control - obvious like laws, and less obvious like the media and modern advertising. To a degree man’s individuality of thought, which is essential to success in investing, is restricted by his own emotional make-up and structure of society.

Perhaps the perfect example of how keen people are to follow each other rather than standalone was a well known psychology experiment undertaken at a famous American University.

The experiment was to look at the effects of negative reinforcement on learning. Students were to administer small electric shocks to fellow pupils when they failed to answer questions correctly. The idea was to increase the voltage to see if learning speed could be quickened by administering shocks with progressively higher voltages.

The student taking the shock was actually an actor and there was no physical danger. However, the students’ keenness in this experiment is extremely interesting. At the start of the test, the Professor in charge announced that he would take full responsibility for the test. The students’ keenness to administer greater and greater shocks without question left the actor almost faking death. Interestingly, when one student suddenly announced he was no longer prepared to administer the shocks, due to the potential of a fatality, everyone else then refused as well.

This experiment graphically illustrates how eager humans are to confirm with the herd, and how they fail to question following an experiment that could actually lead to the death of one of their colleagues.

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