How crowd behaviour is the basis for technical analysis

While a certain point was made in the book, the substance often got lost in the multitude of examples of madness that the general perception became one of “the crowd is always wrong.”

This is what many believe and they take pride in standing on their individual decision-making abilities. One of my recent readings was The Wisdom of Crowds by James Suroweicky, a recent book on study of the crowd phenomenon. In that book, Suroweicky presents evidence to the contrary of the popular belief that crowds are always wrong. In fact, he goes all the way to the other side (almost) in saying that decisions by groups turned out much more accurate than those made by individuals!

Time and time again, Surowiecki found evidence of collective decisions to be superior to individual results, whether researchers asked people how many jelly beans are in a jar or how much an ox weighs. The “collective guess was very accurate, and was better than the vast majority of individual guesses.”

Surowiecki notes that the wisdom of crowds is not a natural idea to many of his readers. Rather, it is counterintuitive because people are wrongly led to believe that “well-informed will be outweighed by the poorly informed, and the group’s decision will be worse than that of even the average individual.”

A classic example of this can be seen at work in the famous TV show Kaun Banega Crorepati. In this, as everyone knows, the participant has three helplines — a 50:50 (eliminate two answers out of four), phone a friend or expert or audience poll. The first one has odds of 50 per cent. The second one it was found, returned odds of only 61 per cent of being correct even though questions were asked to experts. The third (audience poll) actually turned out to be correct 91 per cent of the time!

One of the explanations offered for this is that the audience consists of a diverse group of individuals and the more diverse the group is, the more intelligent it is. Reading through this book, I am reminded of another classic book on crowd psychology, particularly related to markets, Forecasting Financial Markets by Tony Plummer. In that book Plummer states, “Intelligent investment demands that we stand apart from the influence of crowds.” This may seem contradictory to what Suroweicky states but it really is not. Plummer says that in the context of the Market Cycle that he introduces in that book, one which I have found to be brilliant exposition of how the market works and why prices fluctuate all the time.

At the peaks of the cycle is when the crowd is out of sync, when emotions run high and, as Plummer puts it so nicely, “people at work are no longer looking at the underlying fundamentals but at the fast paced movement of prices themselves”.

Plummer quotes extensively the works of Eric Jentsch, who did some fantastic work on crowd phenomenon and its influence. Both these books (Suroweicky and Plummer) seek to explain and lay the foundations for why technical analysis works. Anyone interested in the subject should certainly give these two books a whirl. Not your casual weekend reading, I would want to warn you! But once you read and digest what they have to say, it will be difficult for you to view the market quite in the same way that you did before!

Our response to news and events remain colored thru our own perceptions of what the news or event could mean. However, the market’s response to the same news and event is the response of crowds and that is what really sets the price trend. Accepting this truth, that markets are forever bigger than the individual, will be the major step in our own evolution as analysts and traders and investors.