What Inflates Investment Manias?
Markets share with religions, and politics, a tendency to extreme risk-taking...
Posted January 25, 2018
Bitcoin and other crypto currencies may belong with the dot-com boom, and much earlier manias such as the South Sea bubble and tulip mania. To understand investment manias, we need to consider the more general issue of mass delusions that range from military jingoism to religion.
The Psychology of Popular Delusion
All wars are frightful in retrospect but are generally initiated in a mood of unrealistic optimism. One might ask why Germany suddenly changed the bitter defeat of World War I into the euphoric quest of the Nazis for global domination in World War II.
Complex as the answer might be, it could hardly have occurred were they not possessed by an irrational shared optimism similar to that which animates investment manias, political revolutions, and religious movements.
Although there are many types of mass manias and group delusions, all share some basic psychological attributes. To begin with, they involve very one-sided thinking. True believers ignore all kinds of contrary evidence. In the case of investment manias, for example, enthusiasts consider only the possibility of gain. They imagine that the value of their investment can only increase.
Interestingly, very intelligent individuals are just as vulnerable to the euphoria of bubbles as anyone else. Otherwise rational, and skeptical individuals, such as Mark Twain, are liable to lose their shirts in the irrational exuberance of the investing world.
Isaac Newton, sometimes considered the brightest intellect of his day, invested in the South Sea Bubble – a highly speculative play on the promise of future profits in faraway lands.
People invested in such securities with almost no knowledge of what they were buying, and no way of putting a value on the investment – rather like the cryptocurrencies of today. Investors are guided purely by the knowledge that the market price is rising.
That sort of irrationality leads to some bizarre equivalences. At the height of tulip mania (1636-1637), a rare type of bulb was used to purchase a home. In the dot-com boom, companies with revenues smaller than a corner store had market valuations of billions of dollars.
Lack of skepticism is a defining characteristic of religious belief systems, as well, and believing the claims of Mormon founder, Joseph Smith, a convicted con man (1), is equivalent to buying securities from professional fraudsters who profit from South-Sea-type investment schemes.
A delusion shared by many can be every bit as powerful as the delusions of psychotics. Indeed, there is some evidence that we are all vulnerable to accepting notions merely because they are widely accepted in our social circle, a phenomenon labeled “social proof” (2).
This is true even when those ideas violate everything we know about how the real world functions. For example, the Bible credits Jesus with a capacity to walk on water contrary to the normal working of gravity. Perhaps, the attribute that unites social delusions more than anything else is the intensity of emotional investment they evoke.
Skin in the Game
One of the most remarkable aspects of investment manias and all other mass euphorias is the extent of personal commitment by true believers. We have all heard anecdotes of cult recruits who donate all of their property to the organization, usually on the strength of conviction about some improbable reward, such as a berth on a spaceship to escape the destruction of planet earth (2) or being united in the afterlife with those whom we love.
Strength of belief goes along with heavy investment in real terms. This relationship plays out in complex ways because investing a great deal in some belief system, or investment mania, increases the strength of a person's faith in the euphoric idea whether of endless profits, or eternal happiness.
Participants not only invest lavishly, and recklessly, they are emotionally invested as well. The mass delusion becomes a focal point of their lives.
Dot-com enthusiasts spent a lot of time watching the gyrations of their favorite investment. Trading in and out of these stocks initiated a way of life known as day trading.
In all investment manias, human decision-making is at its weakest. Those of us who see humans as creatures well adapted to their environments, like other species, are left scratching our heads.
The Human Vulnerability to Mass Delusions
Professing belief in the notion that a tulip bulb is as valuable as a home is a strange excursion into lunacy. Nevertheless, there was a market in tulip bulbs and the market prices encouraged such ridiculous valuations. The true value of Bitcoin is currently unknown but the market value rose more steeply in the past year than tulips ever did. If this is a true investment bubble, prices will fall just as steeply as they rose.
Defenders of market rationality might point to the fact that the highly valued striped bulbs were extremely rare and hard to get. A similar argument is made about gold, precious stones, and cryptocurrencies (that are “mined” by participating in blockchain networks that are expensive because they consume vast amounts of electricity roughly equivalent to the current value of Bitcoins).
Whatever rationale market participants put forward, the risk is clearly extreme. Interestingly, the risks are always well known many months before crashes occur. Warnings about Bitcoin have become increasingly intense over the past year, a time during which its value rose almost 20-fold. Instead of encouraging skepticism, the market has encouraged participants to take ever greater risks.
Social validation helps traders to believe in a sketchy investment thesis and feel like geniuses as their cryptocurrency gained value.
Social psychologists find that people make riskier decisions when they operate as a group and some element of groupthink precedes disastrous military actions such as the Bay of Pigs fiasco.
Looking on the bright side, feeling good about risky decisions may well help us to feel united as a group. However an evolutionist might rationalize it, the madness of crowds is real enough. It has been seen many times before in end-of-the-world cults, Messianic religions, and political extremism, as well as investment manias, Ponzi schemes, and market bubbles.
We may not like the plot outline, but, in the investment arena at least, we know how the story is going to end.
1 Hitchens, C. (2007). God is not great: How religion poisons everything. New York: Twelve.
2 Cialdini, R. (1988). Influence: Science and practice (2nd Ed.). Glenview, IL: Scott Foresman.