Tuesday, December 20, 2022

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.


Friday, June 24, 2022

 My new English book Cycles for Investors is published in Amazon. You can also purchase it in Finnish. It does not promise you superior investment returns, magic formulas to achieve them or help you make exact forecasts about the markets. Instead, it gives you tools to increase your odds to avoid greatest insanity in the markets like buying during bubbles on margin, or selling close to the markets bottoms. It helps you to better understand intermediate and long term cycles related to the financial markets.

About the content of the book

The main parts of the content are the deeper anatomy of the cycles, the cycles related to the national economies, the cycles related to the financial markets and the life cycles of companies. It also addresses the intersection of three important economic cycles and the real estate and commodity cycles. The deeper anatomy of the cycles deals with their psychological profile as well as the factors that shape extremes. National economic cycles include e.g. the cycle of economic development and the cycle of a leading economic country. Financial market cycles include e.g. long debt cycles and stock market cycles. Life cycles related to companies include e.g. technology adoption cycle and industry life cycle. Real estate and commodity cycles have been treated only superficially due to the author’s lack of understanding.

In addition, it explains how an investor can identify the conditions of booms and bubbles prior to collapses. Efforts have been made to present cycles by multiplying their course by cause-and-effect relationships, mostly without numbers. More important than numbers is to understand the course of the cycles and the factors that interact to drive the cycles consistently. The book has focused at least on medium cycles. In perceiving them, numbers can be more misleading if cause-and-effect relationships or the course of cycles are not properly understood.

In today’s world, everything affects everything, so the cycles in the book are more or less related. In particular, the cycles of the national economies and the financial markets are often highly interdependent. Business cycles are also dependent on national economies and financial markets. The latter do not decide the fate of individual companies. It can be said that some companies are not affected.


The book deals with the anatomy of cycles and the following cycles and life cycles:


  • Long psychological / socioeconomic cycle

  • Economic development cycle

  • Leading economy cycle

  • Reserve currency cycle

  • Long and short debt cycles

  • Stock market cycles

  • Technology life cycle

  • Industry life cycle

  • Business life cycle

  • Real estate cycle


The main purpose of the book is to improve the reader’s chances of increasing investment returns by better understanding the cycles related to economics and investments. Improving revenue is most likely to happen by reducing the number of stupid decisions made by readers than by providing magical insights. Warren Buffett and Charlie Munger have often mentioned that they are not particularly wise, but avoid stupidity better than others. This makes sense for the sake of mathematical facts alone. As most people know, a 50% decrease requires a 100% increase, and so on.

The focus is on the extremes and extremes of the cycles, i.e. mainly bubbles, peaks, bottoms, possible crashes, beginnings, and endings. Other parts are less important. One reason for emphasizing the extremes is that, in my view, many long-term cycles are at or near the end or just past them. The ends and the beginnings refer to those cycles without peaks and bottoms. This is the case, for example, with a long psychological / socioeconomic cycle. Extremes are also the moments when the biggest differences are made in investment returns.

In my experience, the book’s publishing platform doesn’t produce clear graphs, so I’ve left them out. I have reduced the time and effort of the reader by keeping the book short. The book is supposed to follow the principle: “the price is what you pay and the value is what you get” In my experience, the number of pages does not match the benefits of non-fiction books.

The book is not for novice investors. It does not explain everything in detail. The reader needs to know what the basic concepts like P / E ratio, Return on Equity and Earnings Per Share mean. A broader understanding of the economy is desirable but not essential. An open mind is also important because the book calls into question many things that at least economists consider true. Independent thinking is also essential. No book offers absolute truth about the economy because it cannot be found. The world is too complex for today’s computing power. This book does not offer it either, as the author knows his limitations.

The book contains a few investment ideas. If they are found, they are vague in the style of "substances used for intoxication can be a good investment in Awakening." (An explanation of the former can be found later.) The book does not contain exact predictions of what is to come, but it gives a broad explanation of what may happen or what is the most likely option for the future. It does not predict when anything will happen.