TCS Daily

Dumb Mobs

By Arnold Kling - July 25, 2002 12:00 AM

Howard Rheingold, a leading chronicler of the phenomenon of community on the Internet, has entitled his forthcoming book, Smart Mobs. It describes the power that Internet technology gives people to gather into swarms suddenly and spontaneously. However, he cautions:

There are the dangers as well as opportunities concerning smart mobs. I used the word "mob" deliberately because of its dark resonances. Humans have used our talents for cooperation to organize atrocities.

Rheingold's mobs are smart only in the sense that they have the means to act rapidly and collectively. We can contact one another and mobilize quickly because we are connected to the Internet, increasingly untethered from desktop computers. We can raise issues and brainstorm action plans using weblogs, instant-messaging, and other high-speed tools of communication.

However, giving mobs smart means does not mean that they will have smart ends. Rheingold cites with evident approval the tactics of anti-globalization protesters and of drivers in the UK protesting the high price of petrol. As an economist, I believe that if such mobs ever were successful -- at stifling trade or imposing price controls -- the results would be tragic.

The Stock Market and the Internet

I believe that the spectacular rise and fall of the stock market in the United States in the last several years can be attributed to the behavior of swarms of investors that were fostered by the Internet. We might call these "dumb mobs."

Why are dumb mobs so powerful?

The swings in stock prices are remarkably wide. The fundamental determinants of stock prices ought to be inflation, interest rates, expected growth of earnings, and changes in the "risk premium" that investors apply to stock prices. However, it is not possible to find plausible explanations for the sharp movements in stock prices by looking at the underlying fundamental factors. The fundamentals tend to move more slowly and within narrower ranges than stock prices.

Stanford economist Mordecai Kurz has developed a theory to explain wide market swings, based on shifts in what he calls rational belief equilibrium. What his abstract model says (I think) is that at any one time it may be rational for some investors to believe that the price-earnings ratio for stocks ought to be high (say, 100) and for other investors to believe that the P/E ratio ought to be low (say, less than 15). There is never sufficient empirical evidence to invalidate either belief.

If the mob of bulls starts to develop some momentum, then according to Kurz, the bears start to modify their beliefs in a bullish direction. The bullish mob expands and becomes more powerful. Conversely, when the bears begin to gain momentum the bulls start to change their beliefs to become more bearish, and a large downward swing ensues.

How did the Internet foster the growth of dumb mobs?

Mob psychology has been around for a long time.

In reading the history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons of excitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first.
--Charles Mackay, Extraordinary Popular Delusions And The Madness Of Crowds, 1841

The Internet helped to stimulate a mob stampede into stocks in a number of ways.

It lowered transactions costs for investors. The cost of stock trading dropped dramatically when Internet-based brokers introduced competition in fees.

Young people became attracted to the stock market by seeing the success of companies such as Netscape, with which they identified. Internet stocks became the phenomenon on which "whole communities suddenly fix their minds," to use Mackay's phrase.

More people, particularly overseas investors, gained easier access to information and trading on U.S. markets. From chat rooms to financial information sites, investors could be more stimulated, if not more informed, more than ever before.

The emergence of the Internet itself was a plausible basis for a "new economy" outlook. People saw Internet-based commerce as leading to faster growth of output and productivity than occurred in the past. The belief in the possibility of such a new economic regime is one of the important elements of the Kurz model of volatility.

Overall, at the lend of the last millennium, an influx of new investors with strong faith in the Internet revolution added momentum to the bullish mob. Stock prices became less and less sustainable, until the break occurred in March of 2000. Since then the bullish mob has been in retreat, and more recently the bearish mob accelerated its stampede.

Can the market be insulated from dumb mobs?

There are alternatives to having a stock market ruled by mobs. Unfortunately, those alternatives are probably worse.

We could restrict stock market investing to licensed professionals. However, the pros are just as subject to mob psychology as the amateurs. Overall, market consensus tends to be wiser than the opinion of even the smartest investors.

We could try to increase the cost of trading, through taxes and/or restrictions on certain types of trades. However, it is not clear that doing so would reduce volatility. Such interventions in fact could be destabilizing.

How should an individual investor deal with dumb mobs?

I believe that individual investors need to exercise patience and discipline. Patience means staying out of the market (or having a portfolio that is underweighted in stocks) for long periods of time when the bulls are running wild, and staying in the market for long periods of time when bears are going berserk. Discipline means buying and selling on the basis of fundamental valuation, not on the basis of rumor or hope of a quick killing.

From a patient, disciplined perspective, you do not try to achieve perfect market timing. All you want to do is have more of your money in the market when stocks are cheap, and less of your money in the market when stocks are expensive. Today, relative to GDP, stock prices are lower than when Alan Greenspan warned of irrational exuberance in late 1996. That does not mean that the market is at a "bottom." As Megan McArdle points out, one can argue that the P/E ratio on the S&P 500 stock index is still a bit high. However, today I am comfortable putting a higher portion of my portfolio into stocks than I had at any time in the past 5-1/2 years.



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