Psychological tendencies related to financial bubbles, booms and crashes

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.