Munger and the Impact of Crowd Folly

In November 2000, legendary investor and Berkshire Hathaway Vice Chairman, the late Charlie Munger, gave a speech at the Philanthropy Roundtable, where he went into great detail about “wealth effects,” something that tends to happen when stock prices rise.

According to Munger, as stock prices rise, people have a tendency to spend more and this effect works both ways: stock prices are concurrently driving up spending and increased spending tends to drive up stock prices. He says that this can also lead people to make irrational decisions, driven by a herd mentality or what he calls “crowd folly.”

Crowd folly: What it is, how it works, and the impact

In his speech, Munger says: “‘Crowd folly,’ the tendency of humans, under some circumstances, to resemble lemmings, explains much foolish thinking of brilliant men and much foolish behaviour — like investment management practices of many foundations represented here today. It is sad that today each institutional investor apparently fears most of all that its investment practices will be different from practices of the rest of the crowd.” In simple words, sometimes, even the smartest investors can follow the herd and make mistakes.

• Smart people are not immune to herd mentality: One of Munger's most important points is that intelligence does not necessarily protect us from making bad choices. He specifically refers to the “foolish thinking of brilliant men,” challenging the assumption that sophisticated investors will automatically behave rationally. Crowd folly isn’t simply about uninformed investors making bad decisions; even experienced professionals can get swept up in the same enthusiasm.
• Rising prices become “justified”: Munger also challenges the idea that stock prices always reflect a rational assessment of value. Common stocks are valued partly on their ability to generate future profits, but they can also be valued simply because their prices have gone up before. This can create a vicious cycle: investors see prices rising and conclude that something must be driving the increase. More investors participate, pushing prices even higher and the rising price begins to look like evidence that the investment was a good idea.
• The fear of being different morphs into the fear of missing out: Munger's sharpest observation is that institutional investors often fear that investment practices that are different from the rest of the crowd are not sound. If everyone invests in the same businesses with the same strategies, individual investors will feel less alone if things go South. Taking a different approach carries its own risk, creating even more incentive to follow the herd.
• Crowd folly becomes unnecessary excess: Eventually, this collective optimism turns into collective excess. As more people participate in a bull market, confidence grows. Rising prices create wealth effects and those wealth effects encourage more spending and optimism. That optimism further reinforces the belief that prices will continue to rise — without stopping to question whether any real value is being generated.

The enduring lesson… The fear of missing out and being different can all influence investment decisions. During a strong bull market, these pressures can become even more powerful because rising prices appear to confirm that the crowd is right. And this is exactly what Munger warns against. Crowd folly is ultimately a reminder that markets are made up of people, and people are not always rational, even when they are highly intelligent, experienced, or professionally trained. So one must be willing to question the crowd and form an objective view.