Investment Behaviour and Bubbles
A key assumption of most financial models is that investors are rational and risk averse. Most academics would also agree, to varying degrees, that markets broadly reflect all publicly known information and are priced accordingly.
These theories (1) would suggest that it’s impossible for speculative asset bubbles to form. However, anyone with only a passing interest in investments and finance will know that this is certainly not the case. Indeed, asset bubbles have beset the investment landscape for hundreds of years. When investment loses its economic rationale, we move into the realm of speculation only explained by human psychology.
One of the first recorded bubbles was Tulip Mania in 1600s Netherlands, which famously claimed Sir Isaac Newton as one of its victims. Tulips represented status symbols and prices soared to a purported $1 Million per bulb in today’s money for the most sought-after specimens (2). These sky-high prices dramatically dropped in 1637, driven by bulb buyers being unable to repay loans they had taken out to fund their purchases.
Another famous early bubble is the South Sea Bubble and more recent examples include the Dotcom Bubble at the turn of the millennium and the 2000s American Real Estate Bubble which was the key driver of the 2007-2008 great financial crash.
Bubbles occur when asset prices increase dramatically, trading at extreme multiples of an asset’s real, fundamental value. What drives people to invest at these high prices is their human emotions, particularly the two key drivers of greed and fear.
Investment Greed
The role of greed in forming bubbles is perhaps the most obvious: prices are going up, so I should get involved in sharing all the money that is certain to be made. Investors can have a habit of chasing ‘the next big thing’ whether that be biotech, AI or crypto currency, to name just a few recent headline grabbing areas.
The inherent problem is that it’s more than likely that they have missed buying these assets at a reasonable price, which vaguely reflects their real, fundamental value. Instead, the rationale is that they will sell at higher price at some point down the line to someone who is willing to buy at even more inflated prices – The Greater Fool Theory. Of course, this strategy only works whilst there are greater fools out there. When the music stops and there aren’t any, the asset price will tumble. A key risk is that you may have been the greatest fool of all and bought right at the top, just before the bubble burst.
Investment FOMO
In terms of bubbles, fear is the Fear of Missing Out (FOMO). Even the rational amongst us can find it hard to stand at the sidelines as friends, peers and colleagues reap the rewards of their speculative investments following the current flavour of the month. As long as the bubble keeps inflating, it can be difficult to remain confident in yourself and your investment strategy, no matter how sensible it is.
The temptation to throw caution to the wind can creep in. However, resisting this can be crucial in avoiding serious financial pain. The sensible approach is to focus on long-term returns, rather than trying to make a quick buck although this goes against our innate human desires for immediate reward.
Optimism and over-exuberence
Another emotional aspect to consider is our propensity to latch onto optimistic sentiment. Rising markets breed excitement, and market exuberance grips professional investors and the general public alike. During such bull markets, the media will start to report record market highs, interview those who’ve made big money and fuel the fire.
Bullish sentiment starts to embed and becomes difficult to shift; anyone advocating caution and restraint is brushed-off as ignorant and misinformed, an obstructionist or perhaps just a bit boring (see social media discussions on cryptocurrency for a case in point). We fundamentally don’t like to hear information which opposes our beliefs or suppresses our ambition; we all to some extent willingly suffer from the ‘Ostrich Effect’ (3). This intentional ignorance to contrary information can help fuel price rises. If at any time there are more starry-eyed buyers than sellers, those sellers can keep commanding higher prices for their assets.
Most of us like to feel like we have a good handle over our emotions. Not many people would admit to being greedy, fearful or willfully ignorant, but recognising our emotional responses is key to successful long-term investing. It would be near impossible to not feel at least a slight pang of anxiety if your investments lost 10% of their value in a day, or conversely a slight dopamine rush if they were up by 10%. However, making ourselves stand back and objectively assess our investments and our financial goals can help us avoid emotional responses and getting caught up in bubbles.
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(1) Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH).
(2) Hayes, Adam. Tulipmania: About the Dutch Tulip Bulb Market Bubble. Investopedia. [Online] November 11, 2022. https://www.investopedia.com/terms/d/dutch_tulip_bulb_market_bubble.asp.
(3) Kamalodin, Shahin. Asset bubbles, financial crises and. Utrecht : Rabobank, Economic Research Department, 2011.
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