In my experience, most investors are quite astute. They understand that the concepts of risk and return are intimately connected, and that higher returns generally require them to take more risk. In these current times of global credit crisis, while markets are gyrating madly, these savvy investors grit their teeth and hang tough. They know their portfolios are broadly diversified, and they know that all this is just the “risk” part of the equation.

But at certain times in the financial markets, players suddenly seem to lose their heads. Risk is perceived as having left the building by the back door and certain wealth is arriving at the front. At such times, even the most hard-headed investors can lose their perspective and scramble to take bets. What happens is a form of financial mass hysteria.

Researchers who study “the madness of crowds” know that it has its own peculiar psychology. For one thing, the insanity tends to feed on itself, becoming more intense as the number of participants goes up. For another, nobody caught up in the frenzy sees anything wrong with what they’re doing. At the time, it seems irrational to do anything except join the crowd. Only after the fact does the madness becomes apparent.

In our age of “instant information” and constant media barrage, it’s easy to get a crowd together and whip it up into a frenzy. Most of the investors burned by the tech meltdown of 2000 had joined the crowd to buy tech stocks only a couple of years earlier. Back then, such stocks seemed the only sane investment, since nothing else seemed to be making money.

But lineups for bad investments are nothing new. In fact, they date back almost 400 years, to 1636, when all of Europe was going wild over exotic new flowers imported from Turkey. These “tulips” became hot commodities, worth fantastic sums of money. Prize bulbs were even considered a form of currency, and bidding wars erupted over the most coveted varieties, with fortunes gained and lost. Later economists dubbed this “tulip mania,” and used it as a prime example of how crowd psychology can overpower common sense.

Less than a century later came the so-called “South Sea Bubble,” which expanded for a decade from 1711 until it exploded in 1720. The South Sea Company obtained a monopoly from the King of England to trade in the exotic New World. So convinced was the English stock-buying public that inexhaustible supplies of gold and silver awaited there the stock was many times over-subscribed -yet the company never actually floated a single ship. Of course, eventually the bubble burst and most subscribers lost their shirts.

In both those cases, and in other more recent ones, throngs of investors from all walks of life demanded to be allowed to buy into the opportunity to purchase shares. It seems there’s something devastatingly similar about once every generation. Remember the IPO frenzy of the late 1990s? Investors flocked to tech stocks merely on the basis of a “concept,” with no concern for revenues or even a tangible product. Stocks soared to billions of dollars of market capitalizations as soon as issued; two years later, the company was usually out of business.

Here’s the thing about such frantic queues to buy: they form because buyers perceive themselves to be getting a tremendous bargain – the sellers are offering something at a fraction of its potential value. That illusion of value is so compelling that normal caution is suspended, negotiations are sidelined, and buyers are willing to open their wallets at just about any price. They’re partly bedazzled by a great deal, and partly scared that if they don’t move immediately, someone else will cash in on what could have been theirs.

The point about those scenarios is that they assume that the sellers don’t really know what they’re doing. But if sellers already own the valuable stuff you’re lining up to buy, then just why ARE they selling it? Are they so dumb that they can’t see its value, though you can? Maybe they’re true philanthropists: they have this treasure all to themselves, but instead of hanging onto it they decide to spread it around for the good of their fellow human beings. How likely is that?

The great investors, like Warren Buffet, never get suckered into crowd psychology. He made a name for himself in the early 1970s, when he bought stocks nobody else would touch. Recently, he’s been nosing around the bond insurance market – again, because no one else is interested. (Thanks to the credit crunch, U.S. banks now have to pay the same amount for bond insurance as the country of Nigeria.)

That’s not to say that the mass of investors is always wrong, of course. There HAVE been investments – though few and far between – where after a public buying frenzy, investors have made significant gains. Some much-hyped IPOs go on to do very well. On the whole, though, be warned: most typically under-perform the market for at least the next ten years.

So if you ever feel “the madness of crowds” coming over you with respect to a new investment, just pause and ask yourself this question: “If I’m part of a whole gaggle of buyers, who’s more likely the sucker here – the seller, or me?”