Smart traders profit from the wisdom and delusions of the crowd

Crowds can be wise, but also manic and delusional. An astute trader learns to differentiate between these two extremes.

When there is diversity of opinion, the crowd is a force. The parts think independently, but private judgements combine to join as one powerfully wise collective.

Unfortunately this intellectual juggernaught will not last forever.

At some point diversity gives way to homogeny. Diverse thinkers conform to the will of the group. The smartest person takes the lead, which leads to less variance of opinion and acquisition of knowledge. The group no longer leads, but follows with irrational cognition as crowd psychology takes over the group.

The group is now set up for "popular delusions" and "madness of crowds".

Bubbles form that inevitably pop.

We have seen this play out for centuries. What startsas wise investing turns into a mania. Examples are too numerous to list, but here are a few:

• 1700s Tulip Mania: at one point tulips were more valuable than gold
• 1700s South Sea and Mississippi Company Bubbles: These companies were with more than 80 times all of the gold and silver in France.
• 1927 Florida Housing Bubble: A 2 bedroom condo in 1926 cost as much as a large luxury home in Miami today (4.5 million *without* adjusting for inflation)
• 2002 DotCome Crash: Nasdaq lost 78 percent of it's value in 18 months.
• 2009 Housing Bubble and Credit Crisis: Credit and housing mania leads to 50 percent loss in the market in 18 months.

In all of these instances, what started as smart, logical and prudent investing trends gave way to the insanity of the crowd.

Your job as a trader is to identify when wise crowd logic gives way to delusion.

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