Bubbles, Booms and Crashes part 3. Psychology

 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, excess 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.

Psychological profile of financial market cycles

 

Most cycles follow a continuum of the psychological profile in which the majority of market participants experience certain emotions. The continuum according to Wall Street Cheat Sheet from base to base is approximately:

Depression → disbelief → hope → optimism → faith → enthusiasm → euphoria → complacency → anxiety → denial → panic → capitulation → anger → depression

Not all cycles include all stages. Euphoria, panic, and surrender do not occur in all cycles. I did not mention envy, but that is also present. It occurs at all stages. The intensities of emotions vary in different cycles. Not all investments in one asset class face all emotions. This may be self-evident, but it must be mentioned. Investment targets may follow individual psychological profiles. The following description follows the change in psychology as the market wakes up from the previous bottom and moves to the next one.

The depression conquers the market and investing loses its meaning for most of the market participants. The money is gone and there are few professionals left. The previously great investment has left a disgusting thought: “investment xyz, no way!” The loss of excitement about the markets seizes the professionals too. Enthusiasm has become non-existent and hope is lost. P / E figures are low. Prices move a little. They can stay in this mood for years. The greater the euphoria or investment folly, the more depressed the market is on average. Even the depressed market can rise slowly. Most people do not detect the rise and most do not have any thoughts about it. There will be no significant changes in share prices and the stock chart will look almost flat.

The depression in the market will not remain forever. The slope of the rise will start to increase. The market experiences an awakening and an ascent in the market goes up fast. The general public believes in a momentary relief in the market. "The fool's rally on, yes, they will find out that this was just a temporary bounce." The result is a short rally that ends with the repatriation of the profits of the professionals.

The decline is short and prices are rising. The hope of a larger audience begins to awaken and the slope upwards increases. The hope of a price recovery begins to live in the minds of investors. They see the higher probability of ascension and improvement in the market. The eagerness of some of the general public to return to the market rises. There are fewer gloomy ideas about investing. The general public shines with their absence.

After some time of hope, optimism in the market wakes up. The market outlook tells that the price rise will run many years from now and there will be a great possibility to benefit from it. As optimism wakes up, the upward slope steepens. The situation looks good on a broad market. Investing is not just a professional activity. With optimism, it is safe to place your bets and the peak is at a safe distance.

As optimism grows, investors have put most of their money on the broad market. Prices are rising fast and faith in the market is high. It's easy to say, "Now I'm putting it all in and enjoying the price increase." Some are getting rich and large longer-term bills are not immediately known. Borrowing is not a significant factor because the general public has not experienced a long enough rise.

With all of your own money in the market, few investors will lose their money and prices will go up. Enthusiasm is widespread and there is no fear of tomorrow. The general public believes that it is safe to borrow money for investment because it is easy to offset interest rates on loans with profits. The prevailing thoughts: “We have to spread the delightful message of easy profits to everybody we know because they need to get rich too!”

The euphoria of the ascension phase does not always occur. It occurs on a large scale a few times in a person’s lifetime. Few believe that they can lose money. The general public believes everyone will get rich. The prevailing thoughts are, “I’m a genius,” “I will make more money I can spend,” “I don’t have to work.” When Euphoria strikes, many professionals believe that the general public will lose their money, but they return to the market to make money with the last euphoric price movement. When real euphoria strikes, many prices will rise by hundreds of percent in a few years and no one is afraid of losing. The slope of the ascent is the steepest. Stock market listings, their huge volumes and significant price increases on the first day of are the clearest signs of euphoria.

Eventually, the euphoria slowly subsides step by step until suddenly the prices fall rapidly down a few tens of a percent until they bounce up. Prices do not reach the old peaks. Complacency strikes market participants. They expect another massive rise that will not come. The prevailing thoughts are, "Yes, the market is still rising because people are as wise as I am." "Others are still making a lot of money." Instead of a significant rise, the market is fluctuating without moving. This can take several months and there are no big signs of a decline.

Market psychology is slowly changing in a more negative direction because the upward trend is no longer working well. Complacency and faith in new great investment opportunities will disappear and a faster decline towards the bottom will begin. Anxiety strikes. The prevailing thought is, "Why did the bank's approval of my guarantees vanish?"

The situation continues to deteriorate and people are on denial. The decline is only accelerating. Disbelief that the market will no longer properly rise has more power. The prevailing thoughts are: "Fortunately, I chose brilliant investments, which cannot decline anymore, others realize their goodness." The market may still get a little excited and rise.

Eventually, panic strikes and prices fall rapidly. The daily changes are large and the prices of better investments also fall fast. If you have to sell, you can only sell the good stuff. The majority believe it is better to sell before they lose all their money. The prevailing thoughts are, “I have to sell my assets before others” or “Now I must sell so I will not lose everything.” There is not always a panic. Sometimes it takes a few days or weeks before it ends. Wide fronts of double-digit decline rates are normal in panic. No contingency attempts are working. Prices fall as soon as the stock market opens and stop-loss regulations are not low enough.

After a possible severe panic, there is often still a capitulation ahead. The hope of the majority is gone. The prevailing thoughts: "Everything will be lost, why should I care about my assets anymore?" or "I will never invest again." This phase signifies the last possible major downturn before the bottoms. During it, it is safe to return to the market without borrowed money. It is less common than panic.

After a possible capitulation, anger strikes: "Why didn't xyz's CEO X tell the truth that the high return expectations were not justified," "Why do the financial authorities allow the sale of these products?" Scapegoats for losses are found also from short sellers or a neighbor Joe who gave bad advice to invest in an asset where ”everyone makes much money.” Anger towards CEOs and people recommending shares for their profession is often justified. They almost always survive and often get bonuses on top of the deal, unlike their customers. The rationality of anger is another matter.

In the end, the market is depressed. They don't interest anyone. This is the best stage to buy, but few can do it. The vast majority are stuck in negative thoughts: "What a fool I was, now my pension is gone and I'm going to have a poor pension.", "My situation will never improve!" The severity and duration of the depression in the markets depend on the length and strength of the ascension and the emotions connected to it. The next rise is around the corner and the most likely option is a new peak at its end.

How can an individual perceive the psyche of the market? There are clues in the market, but there are so many participants that the collective atmosphere is not easy to notice. The first clues can be found by observing yourself. Are the above thoughts present? Which ones are the strongest? Which of them are most common? You can also follow people who do not usually invest. Are they suddenly excited about investing in your immediate circle or is anyone interested? If you don’t know then ask people if they are interested in investing. Go through a larger crowd if you can.

Follow the media. Are there any headlines in the afternoon papers about investing or special investments? What do the headlines say? Are they positive or negative? Observe how often they are published. Try to find studies that tell you what the average return expectations investors have. The higher the expectations, the more likely euphoria is to strike. The lower the expectations, the more likely the market is to be and stay depressed.

Markets are fluctuating more than they should. The aforementioned emotional turmoil moves them upside down. The best moments of buying and selling are created according to the strongest fluctuations in emotional life of the market. Those who disagree with the excess fluctuations have the probabilities on their side. That doesn’t mean they’re right. It’s good to be outside of the worst emotional turmoil.

PS. You can also find a psychological profile of financial cycles from here