The following text about the most common psychological tendencies that are related to financial bubbles, booms and crashes is an excerpt from my book Cycles for Investors.
Bubbles, booms and collapses are social epidemics and follow their
principles. Epidemics have three components: the right people, the
right message, and the right environment. They are influenced by
several psychological factors such as social proof, authorities,
scarcity principle, excessive self-regard, and the illusion of
availability. They increase both the attractiveness of the message
and the effects of the environment on bubbles, booms and collapses.
Different people have different effects on both individuals and large
crowds.
The messages from the bubbles and booms are simple and engaging. They say everyone gets rich easily and quickly without much effort as long as they invest in new ideas. The message includes attractive predictions of a rise in the pattern “Bitcoin rises to $ 500,000 (now about $ 40,000)” “This time it’s different” is another message available in large-scale bubbles and booms. They often also contain a message of a carefree tomorrow and the prosperity of the nation. The message often has some truth in it, but its significance is exaggerated. The realization of the message is often far in the future, even though the masses believe in sudden enrichment and rapid change. One message is that those who do not participate in the boom are stupid.
Bubbles, booms, and crashes will not occur without massive social proof in which herd behavior is rampant. During booms, it produces a
desire to buy the same investments or consume like large crowds.
Crashes create a desire to sell and reduce consumption while others
do the same. In them, many have to do so because they do not have
enough money to consume. Roughly speaking, the closer and more people
produce social proof, the more confident the individual becomes and
acts like others.
Even large numbers of people can be made to act like a small
number of people as long as the latter has credibility. People have
an inherent belief in authority. In bubbles and booms, a small number
of lucky fools can make millions while believing in the goodness of
nonsensical investments because they have happened to succeed
fabulously for a short time. Usually these ”authorities” tell the
general public what they want to hear. They can get rewards from
people like them or the media. In addition, the masses are demanding
so-called anti-authorities who tell them they are wrong. They are
most often people who have been enriched by the old rules and have
not agreed to pay the prices produced by the bubble or boom. They are
considered losers during bubbles and booms.
The scarcity principle means that the less a person has something
or the harder it is to obtain it, the higher the value. In addition,
it works in the other direction. The bubbles and booms in some
investments have a shortage of supply relative to demand. Large-scale
bubbles are mainly affected by the other side of the coin, i.e. the
fact that money moves fast and enriches a large crowd. The above
raises both the prices of investments and increases absurd
consumption. At the same time, the real economy is growing strongly
which raises the above. Too much money significantly increases stupid
investment and consumption decisions.
The excessive self-regard manifests itself as excessive faith to
one’s own beliefs, qualities, skills, and possessions. Faith of an
increasing mass of investors strengthens with the bubble or boom to
the heights rarely seen, which raises the prices of “hot”
investments. At the same time, larger and larger sums of money find
the above items. Faith is not even shaken by failures or losses. They
are explained by bad luck or some other absurd reason, and in the
worst case, the ego is further inflated. Losses and failures increase
the need for investors to look for sources of information that
emphasize their own beliefs and skills. One major factor in the
bubbles and booms is that investments become more valuable in price
as soon as they are purchased.
The excessive self-regard also increases booms and bubbles, with
big money portfolio managers acting as one of the reinforcing
factors. One of the truths of their work is this: "It's better
to lose money like others than to do something different." Many
of them protect their own jobs. This is reflected in the so-called
hidden indexation of funds, where the investments of the active
portfolio manager resemble the benchmark index, differing slightly
from it. This also applies to other moments, but the phenomenon is at
its strongest in booms due to reflexivity.
The overemphasis on egos is not limited to investors. It manifests
itself in central bankers and other regulators. The majority of
central bankers have had a long career believing in the theories they
have learned and the models they have used. They work well most of
the time while increasing regulators’ confidence in them and
themselves. The performance of theories and models in the short term
increases the excesses of bubbles and booms as well as the
devastation resulting from crashes. It is important to ask whether
the actions of central bankers and the models they use have a
positive net effect?
The illusion of availability means that people give more value to stimuli that are better available. Availability can be both an external and an internal stimulus. It can be improved by an increase in the number of stimuli, recency, or characteristics. Examples of the latter are surprise, novelty, ambiguity, and threat. The illusion of availability is reinforced by the media reporting on fortunate individuals who quickly enriched and took advantage of the new message. The media is full of half-truths or misunderstandings about the basic principles of investing. The illusion of availability is at its strongest when a bubble or boom reaches euphoria. It is also strengthened by other psychological factors.
Avoiding the negative effects of the psychological factors of
bubbles, booms, and collapses is not easy. There are a few good rules
of thumb to reduce the effects. When you find that a security or
asset class is more popular in your immediate circle than others, it
is a likely sign of bubble prices. Combining the former with a new
economy or investment vehicle should be seen as a bigger alarm
signal. Never believe words that contain the message, “It’s
different now,” whoever tells you so.
Don’t listen to people who do not have a proven track-record of
investing at least a decade above the market average talking about
future returns or losses, or who promise high double-digit returns on
investment, even in the medium term. Their numbers in public will
increase during booms and bubbles. At the same time, the number of
people who are wrong is growing. During booms and bubbles, it is even
more important to listen to people who have done better than average
for several decades. The same is true during a crash. Also, don’t
believe people who predict the “end of the world” during them.
Don’t believe yourself if you do not have a better-than-average
return rate, or think you’ll be able to achieve high double-digit
returns in the medium term. Don’t let your ego make you believe you
are right when the price of an investment collapses well below the
amount you paid. This is especially true of the losses caused by the
crash. You don’t have to prove you’re right by immediately
putting more money into a losing investment. This is a mistake
because there is no need to quickly return an erroneous investment
with the same investment target. It is safer to take a breather and
think about what went wrong.
Do not look at the price of a security before making a cash flow statement. Your subconscious can steer the end result towards it when its availability is high. Do not look at the price you paid when making a new cash flow statement for your investment. Your investment does not know how much you paid. The price you pay may not matter at this time.