“We cannot reason ourselves out of our basic irrationality. All we can do is learn the art of being irrational in a reasonable way.” (Aldous Huxley).
The madness of crowds
None of us are rational investors. We’re humans – fuelled by fear, overconfidence, and sometimes greed – to survive.
Psychologists have long argued that we allow ourselves to be influenced by the “madness of crowds”. Mob mentality, herd mentality, groupthink – the concept has many names. But they all boil down to the same idea: Individuals are influenced by a larger group. So, if tech stock is on the rise, FOMO kicks in, and we all invest more in tech.
Most of us would like to be invested in the top-performing investments year after year, and we may chase performance by continually shifting our portfolios toward what’s hot. A common problem with this kind of performance chasing is that the hot stock cools off!
It’s not just speculative assets like cryptocurrencies or meme stocks that can be prone to bubbles. When a new technology or product that has the potential to reach a vast new market is introduced, we tend to bet on many of the companies that provide the technology or product as if they will each become the leading player in that market. This can result in the entire industry being overvalued … until reality comes into play, and the bubble pops.
In 1636, the Tulip Mania bubble burst when investors in Holland began frantically buying up tulip bulbs. The bulbs were a highly prized status symbol, and the prices of the desirable varieties went through the roof. At the height of the craze, each bulb cost more than a year’s salary for a skilled worker in Amsterdam. By 1637, things reached a head when the cheapest bulbs reached absurd prices. Demand collapsed, and values nosedived, leaving many investors in the doldrums.
A similar thing happened with ostrich feathers in our own country – Oudtshoorn today is a shadow of its former self.
We’re all far more familiar with the dot com bubble. The NASDAQ rose from 745 points at the beginning of 1995 to 5048 in March 2000. When the bubble finally burst in 2002, the NASDAQ saw 78% of its value wiped away. The value of tech-heavy S&P 500 was nearly halved, and the shockwaves were felt globally.
Speculative investing can be exciting and rewarding, but it can also be dangerous and costly. That’s why you should be careful when approaching speculative investments and only allocate a small portion of your portfolio to them – and even then, only if you really can afford the risk.
Watch out for the signs
According to the authors Larry Swedroe and Ben Henry-Moreland, four main signs of prominent market delusions have been present in the various bubbles since the 1990s.
- There is a story of a vast potential market for a new technology or product.
- Investors and entrepreneurs tend to ignore the possibility that competition will squeeze profits for existing companies and reduce expectations for future revenues.
- Companies focus overwhelmingly on growth in users or revenue as the primary metric rather than profitability.
- The valuations for these companies grow with no connection to their underlying fundamentals.
Though it may not be possible to time exactly when a big market bubble will burst, these signs make it highly likely that a correction will happen eventually.
There is such a thing as a free lunch
The obvious way to avoid getting caught up in prominent market delusions is by remaining broadly diversified across markets and investing sensibly.
Diversification ensures that some of your money will always be in the best-performing segment. Of course, some will also be in other segments, including those that aren’t so hot. While that may not be as exciting as loading up on the “latest and greatest,” diversification provides a less risky and more even-keeled way to grow your money over time.
The real beauty of diversification is that it produces superior long-term returns while smoothing out the volatility en route. This muting of sharp ups and downs is vital. It helps protect you from your most dangerous hindrance as an investor – your own emotions.
When you hear about a newbie investment opportunity and are urged to join the crowd, please come to us first. We want to do the research for you and assist you in deciding whether it’s hot or not.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.