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  Contemporary Crashes More Severe

  So there are remarkable similarities in market bubbles, but there is also one important difference in the most recent booms and busts. Holland, France, and England were still prosperous after their bubbles imploded. Many speculators lost their homes, their businesses, precious metals, and other valuable assets, but the countries’ economies remained strong and continued to grow stronger as the years passed. The bubbles from the 1960s to the early 1990s, although high for any period, also did little longer-term damage to the economy; the nation continued to prosper and grow. However, the last two bubbles in Table 1-2 are a very different species. Not only have more recent bubbles occurred much more frequently; they have also caused more damage. The dot-com bubble and crash of 1996–2002 is estimated to have cost investors $7 trillion and forced millions of people of retirement age to continue working because of major losses in their pension plans.

  The enormous loss of wealth was also due to keeping interest rates far too low for much too long under first Chairman Greenspan and then Ben Bernanke, his successor at the Fed. This disastrous policy was instrumental in setting up the recent financial crisis, which is estimated to have caused losses of $25 trillion to $30 trillion in security values alone. Added to the cost were lost GDP, lost employment, and other major charges that brought the total loss much higher. We can also see that losses in contemporary manias are as high as and sometimes considerably higher than in those in centuries past. The price of South Sea Company stock appreciated 720 percent to its peak, while the price of tulips ran up 1,500 percent. The price of Qualcomm stock, by comparison, skyrocketed over 22,000 percent to its high, Yahoo! 18,000 percent, and Amazon.com 7,500 percent. Dozens of other dot-com stocks appreciated several thousand percent.

  And all of this happened despite the fact that investors were the best educated in history. They commanded powerful state-of-the-art computers and instant communication and had up-to-the-nanosecond data at their fingertips, as well as the finest research money could buy. All the tools of logical decision making were better than ever; only the outcomes were among the worst on record. All of this is why gaining a better understanding of the psychology of both investors and the market is so crucial. The psychology of investors’ overreaction is only now being researched in detail by scientists in the fields of cognitive psychology and neuroeconomics, and the work is providing new answers about why and how bubbles take place and, importantly, how the same forces that generate bubbles influence our investment decisions in any kind of market. This research has added greatly to the basic appreciation of the irrationality of investors’ behavior popularized by some very astute pioneers.

  Understanding Bubbles: The Early Years

  Far from faddish, modern psychological insights applicable to market behavior have grown over 170 years. One of the first steps of scientific method is accurate observation. This is as true in psychology as it is in chemistry, medicine, or other scientific fields. As far back as the 1840s, the Scottish journalist Charles Mackay used his astute powers of observation to develop the antecedents of behavioral finance. He wrote a remarkable book, Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841 and still in print.

  Mackay examined the three historic bubbles we have discussed—the Dutch Tulip Mania (1630s), the English South Sea Bubble (1720), and the French Mississippi Bubble (1720)—as well as other instances of crowd madness from alchemy to the burning of suspected witches and sorcerers at the stake. He declared, “We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it. . . . Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. . . . Men, it has been well said, think in herds . . . go mad in herds, while they only recover their senses slowly, and one by one.”4 The characteristic he observed repeatedly was that when the enormous surge of speculative enthusiasm ends and the bubble begins to implode, the crowd becomes as extreme in its panic as it was euphoric. Caution and rationality are lost in the stampede to sell. In a market collapse, terrified investors are oblivious to fundamental value, just as they were when no price was too high to pay.5 Mackay captured the flavor of mania and panic as well as any writer to this day.

  Picking up from Mackay, Gustave Le Bon wrote The Crowd: A Study of the Popular Mind, published in English in 1896. Le Bon was a French social psychologist, sociologist, and amateur physicist. His book brilliantly caught the actions and moods of the crowd that Mackay had described. Le Bon wrote, “The sentiments and ideas of all the persons in the gathering take one and the same direction. . . . A collective mind is formed . . . presenting very clearly defined characteristics. The gathering has thus become . . . a psychological crowd.”6

  A most striking feature that Le Bon noted was a crowd’s inability to separate the imaginary from the real: “A crowd thinks in images, and the image itself immediately calls up a series of other images, having no logical connection with the first. . . . It accepts as real the images evoked in its mind, though they most often have only a very distant relation with the observed fact. . . . Crowds being only capable of thinking in images are only able to be impressed by images.”7

  To a crowd, few images are more seductive than the promise of instant wealth. The picture of vast riches that would normally take a lifetime of hard work to accumulate, if you were lucky, being won effortlessly in just a few days or months is almost irresistible. Think of all of the house buyers in the early 2000s who took on huge mortgages they knew they really couldn’t afford. There’s no question that Mackay and Le Bon were outstanding observers far ahead of their time, but what wasn’t available to them is the recent research that explains in more detail why crowds can be swept away to such levels of irrationality.

  A Glimpse at the New Psychology

  The psychological studies that explain a good part of these consistent and predictable behavioral errors began in the 1970s. That work eventually earned two of the leaders in the field, Daniel Kahneman and Vernon Smith, the Nobel Prize in Economics in 2002. Even more cutting-edge research began coming out after I published Contrarian Investment Strategies: The Next Generation in 1998. The new research provides major findings in both cognitive psychology and neuroeconomics that explain why bubbles are so powerful and repeat themselves so frequently, as well as why contrarian strategies have worked so well over time and should continue to outperform other approaches in the years ahead.

  Just as psychiatrists have learned much about the functioning of the human mind through the study of disturbed patients, researchers in this field have investigated manias and crashes to gain valuable insights into financial decision making. Investment bubbles are the clearest examples of investors’ overreaction because the disparity between value and price is at its most extreme.

  I think this work is only the beginning in this exciting field.

  This research helps greatly to explain why people become caught up in manias and bubbles and why it is so hard to recognize what’s happening. So let us bid adieu to the wry and humorous images of eighteenth-century English duchesses and red-faced twenty-first-century investment bankers, all desperately scurrying after beckoning fortunes, and move on to the emotions that bring them to this state.

  Chapter 2

  The Perils of Affect

  YES, IT’S AMUSING that investors poured money into all the historical bubbles described in the previous chapter. Even Bernie Madoff might envy the promoters back then. Their schemes were far less sophisticated than his, and if you got caught you didn’t go to jail and have your underwear auctioned off to boot. But it’s anything but funny to think of the millions of people who have taken brutal hits on their retirement funds and financial nest eggs.

  Although the findings we’ll consider about the psychology of investor and market behavior are increasingly followed by interested investors,
the majority of economists, financial academics, and Wall Street professionals still dismiss the idea that psychology plays any role in investment decisions. I’ve written about and participated in parts of this work in cognitive psychology, sociology, and experimental psychology since the late 1970s, and there is no doubt that these findings are important to our understanding of market phenomena that entrap us repeatedly; this is why we’ll look at them in some detail over the next two chapters.

  Until a few years back, I continued to be perplexed by some key market events. Although a lot of the blanks had been filled in, an important piece still seemed missing from the puzzle. It’s the piece we looked at in the previous chapter: why do crowds go as berserk as they do in manias and panics? How could they pay $75,000 (in today’s purchasing power) for a rare tulip and then some months later refuse to pay $750 for it? How could investors shell out $150 a share for Red Hat, a sizzling computer software company, in early 2000, and only $3 a share not even two years later?

  What is it that drives the supposedly totally rational investors of the late twentieth and early twenty-first centuries into speculative frenzies even more damaging than those of centuries ago?

  Yes, cognitive psychology, social psychology, and a score of related disciplines have been extremely helpful in pointing out numerous psychological errors that investors make and how understanding these mistakes can both protect you and help to make you some very good money. Still, none of the psychological research could answer the question of how price movements can be so extreme or how euphoria can turn to panic in almost the blink of an eye.

  Affect: A Powerful New Psychological Influence

  Fortunately, there are now answers. Beginning with work in the early 1980s and drawing increasing interest from researchers in the last two decades, new and dramatic findings have begun to emerge to answer this question. Not only do the answers form the core of our understanding of why bubbles occur so frequently and result in such enormous price movements in manias and panics; they also address many other market questions, some of which are critical to our investment decisions, as well as others that cut through the heart of contemporary risk analysis.

  The most important discovery is that of Affect, or the Affect heuristic, as it is sometimes called, which has only recently been recognized as an important component of our judgment and decision making.*3 What the Affect findings have shown is that our strong likes, dislikes, and opinions, experienced as feelings such as happiness, sadness, excitement, and fear, can, either consciously or unconsciously, heavily influence our decision-making processes.

  Affect can work either on its own or in tandem with our rational decision-making processes within or outside markets. Affect is emotional, not cognitive, so it responds rapidly and automatically. The response, being emotional, need not be rational, and often isn’t.

  Professor Paul Slovic, a leading authority on cognitive psychology, whose work, along with that of Daniel Kahneman, a Nobel laureate in economics, is central to our look at Affect and heuristics, wrote: “Images, marked by positive and negative affective feelings, guide judgment and decision making.”1 That is, representations of objects or events in people’s minds are tagged to varying degrees with positive or negative Affect. A rabid sports fan, for example, will have positive representations for a favored sports team and negative ones for an archrival team. Slovic’s paper continued: “People use an Affect heuristic to make judgments. . . . People consult or refer to an ‘affective pool’ (containing all the positive and negative tags associated with the representations consciously or unconsciously) in the process of making judgments.”2

  We all know that we often develop very intense likes or dislikes that probably taint our judgment. And I’m sure you’ve found that if someone has a strong political or religious view, it is very hard, if not impossible, to change his or her thinking, no matter how powerful the argument you think you have presented. There is evidence that any such arguments will in fact actually only bolster your interlocutor’s view. He may, for example, categorize your argument as a stereotypical response. Similarly, the more we like an investment choice, the stronger the positive Affect we have for it; and the more we dislike a stock or industry, the more negative the Affect it produces on us. And as in the case of political views, further positive news reinforces our positive Affect for a security while negative news reinforces our negative Affect for one we don’t like.

  Affect plays a central role in what have become known as dual-process theories of our mental processing of information.3 As the psychologist Seymour Epstein states, individuals understand reality through two interactive parallel processing systems. The rational-analytic system is deliberative and analytical, functioning by way of established rules and evidence (such as mathematics and engineering). The other system, which psychologists have labeled the experiential system, is intuitive and nonverbal. The experiential system draws on information derived from experience and emotional recall and encodes reality into images, metaphors, and narratives to which affective feelings have been attached.4

  Being emotional, not cognitive, the experiential system is much faster than the rational-analytic system, which may take many days or weeks to gather and put together all the required parts. Notice how quickly a reaction starts to form in our minds if we think we’ll have a big investment gain (positive Affect) or we have a wipeout in a favorite stock (negative Affect) or even hear words such as “kidnap” or “drive-by shooting.” Affect can be such a powerful emotional pressure that it can insidiously override our training and experience in the marketplace, and, as we’ll soon see, it goes a long way toward explaining extreme stock mispricing.

  Images and associations are pulled into the conscious mind from past, current, and hoped-for experiences. And the more intensive our positive or negative feelings are, whether about ideas, groups of people, stocks, industries, or markets, the more intensely Affect influences our decisions on them.

  Affect may also have an influence on eyewitnesses to an accident or a crime. They are often poor witnesses, and find it difficult to reconstruct events, as they are focused on one emotional detail or another. The Affect system, anchored in emotions, can at times be far from completely rational.

  Although analysis is critical to many decision-making circumstances, reliance on Affect and emotions is a quicker, easier, and more efficient way to navigate in a complex, uncertain, and sometimes dangerous world. In periods of great anxiety and uncertainty, it is quite natural for the experiential system, often dominated by Affect, to take over.

  A key reason is that Affect often has the power to overwhelm our analytical, rational-analytic memory banks, substituting its independent memory bank of related events and their emotional accompaniments. Easy to use, yes, but sometimes extremely dangerous. Every bubble we looked at in the previous chapter, as we shall see, had Affect at its base.

  You may already have guessed that Affect can also be a powerful subliminal force likely to sway an investor’s judgment when information is sizable but still incomplete or conflicting and yet a decision must be made. In a strong market investors are often mesmerized by the major gains already made and mouthwatering images of even larger gains ahead. The experiential system easily subdues the more cautious images of the rational-analytic system. In the inevitable panic that follows a bubble, the Affect images change dramatically. We no longer think of enormous gains to be made by holding stellar investments. Now we are forcibly introduced to negative Affect. The Affect system flashes out images of crushing losses ahead. The more the stock falls, the more powerful the negative Affect gets. “Sell, sell,” flashes in the mind of most investors before the stocks drop even further. Before long, the image becomes one of total doom ahead.

  Affect is by no means limited to the marketplace. Successful marketers of anything from cars to the world of fashion have capitalized on the effects of Affect for decades to manipulate buyers’ preferences for their products. Researchers are beginning to study its pow
er in motivating groups to take actions that are sometimes silly, sometimes deadly, in many other areas of behavior, from rioting sports fans to murder. At its darkest there is genocide; dozens of repulsive episodes have taken place since the Holocaust, even though the war crimes trials in Nuremberg in 1945–1946 and the International Court of Justice in The Hague in 1945 laid out rigorous punishments for it. Hatred promulgated by Affect at its extreme can become so deep that the victims are no longer thought of as humans but as predatory animals that must be exterminated in order to survive. Affect can cause behavior to move many standard deviations away from the norm.

  Affect can also act very subtly. For example, you think Merck looks good and pharmaceutical stocks are depressed, but there is more information you want to go through. However, you don’t have the time to get all the data you need because the stock is moving up. You fall back on Affect, often without knowing it, because it’s in sympathy with your gut feeling and reinforces your willingness to make the decision to buy.

  Reliance on Affect can mislead us, sometimes very badly. If it were always optimal to follow our affective instincts, there would be no need for the rational-analytic system of thinking to have evolved and become so prominent in human affairs.5 It’s time to move on to some of the deadly shortfalls that Affect bequeaths to markets. The experiential system, provided with psychological rocket fuel from Affect, enhances the powerful images of gains. Affect is potentially more helpful or more dangerous because of its emotional rather than cognitive basis.