Bubbles: Large Doses of Effortless Money

Nov 2017 //
Behavioral Finance

With presumably intelligent investors, how do major bubbles inflate within advanced economies? The answer is grounded more in behavioral economics than tradi­tional economics. For example, suppose we asked a group of individuals which decade contained most of the U.S. Great Depression. (The answer is the 1930s.) Suppose further that 90% of people know the correct answer. Now consider various groups of 10 people, where nine of them intentionally give an incorrect answer, the 1920s. What percent of the true test subjects (the one in ten who isn’t faking an answer) do you suppose will identify the 1930s as the correct answer? We’ll give you a hint: It’s probably significantly less than 90%. Why’s that? Call it peer pressure or a presumption that the crowd is normally right. Frequently the crowd is right, but not always, and the exceptions can ruin an investor’s results. From time to time in markets, the combined influences of peer pressure, a mostly uninformed press, the desire for gain and certainty, and perhaps just plain envy produce some pretty unintelligent, uninformed and, frankly, irrational consensus views. It has happened before and will likely happen again. Spotting irrational stock prices is hard to do in real time, since there are usually so many accepted expla­nations (many of which begin with the word “new”). Moreover, spotting the absolute peaks of bubbles is just about impossible. The peaks are products of non-analytical thought, so rational analysis may not do us much good. As Warren Buffett has said, “Nothing sedates rationality like large doses of effortless money.”