Why Do Market Bubbles and Crashes Happen

The US Housing Bubble, the Dotcom Bubble, the Dutch Tulip Bubble, and the more recent GameStop/Meme Stock bubble. There have been many asset bubbles throughout history and there likely will be many more in the future.

Why do they happen? To help answer that question, let’s start out with a real-world story of two different investors that were profiled in Morgan Housel’s recent book The Psychology of Money.

First, Ronald Read was an American philanthropist, investor, janitor, and gas station attendant who made headlines when he passed away in 2014 with an estate worth $8 million. He was the first person in his family to graduate high school and his friends were shocked that he had any money at all.

He had worked 25 years as a gas station attendant and mechanic and 17 years as a part-time janitor at J.C. Penney. He lived in the same home he purchased for $12,000. He left $6 million to a local hospital and library and the rest to two step-children.

How did he accumulate his wealth? He didn’t receive any inheritance and never won the lottery. He did it by living below his means and investing in blue chip stocks over the course of his lifetime and reinvested the dividends. He didn’t try to time the market, but consistently invested and let the compounding growth work its magic.

A few months before Ronald Read died, another person named Richard Fuscone was also in the news. Richard Fuscone was everything Ronald Read was not.

He was educated at Harvard and had an MBA from the University of Chicago. He had a successful career in finance at Merrill Lynch that he retired in his 40s to “pursue personal and charitable interests.”

In the mid-2000s, he borrowed heavily to expand an 18,000-square foot home in Greenwich, Connecticut that had 11 bathrooms, two elevators, two pools, seven garages, and cost him more than $90,000 per month to maintain. His heavy borrowing and illiquid investments left him devasted by the 2008 financial crisis and caused him to declare bankruptcy.

The purpose of these stories is not to say you should be like Ronald and avoid being like Richard. It is to point out that there is no other field where these stories and other similar stories are even possible .

There is no other field where someone with no education, no relevant experience, no resources, and no connections vastly outperforms someone with the best education, the most relevant experiences, the best resources and the best connections. Investing is not just the study of finance. It is the study of how people behave with money (Housel, 2020, p2-3).

Warren Buffet has said:

“Investing is not a game where the guy with the 160 IQ beats the guys with the 130 IQ…Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

Human beings display repeated patterns of irrationality, inconsistency, and incompetence in the ways they arrive at decisions and choices when faced with uncertainty. Behavioral finance attempts to explain how and why emotions and cognitive errors influence investors and create stock market anomalies such as bubbles and crashes.

Key Takeaway:

People are emotional beings and do not always act in a rational manner. These actions contribute to market bubbles and crashes.

Many Investors Underperform

The story of Ronald and Richard illustrate that behavior has more impact than anything else on the outcome. They represent two extremes of investor behavior. Do these extremes happen frequently in the markets?

Morningstar is a well-known provider of investment research on mutual funds. They report mutual fund’s total return performance across a certain time period. This represents how the fund performed over a given time frame, and any investor holding the fund for that entire time frame would experience those same results.

Morningstar also reports the investor return, which is designed to reflect the average investor’s actual experiences in owning the fund, as many investors don’t hold on to funds for long periods of time.

The best performing US diversified stock mutual fund from 2000 through 2009 was the CGM Focus Fund (CGMFX). This fund increased approximately 18% annually, which was very impressive given the S&P 500 was actually down close to 1% per year over this same time period. Unfortunately, the typical CGM Focus Fund investor managed to lose 11% annually during that same time period, according to Morningstar.

How did this happen? After every period in which the fund did well, investors piled in. After every period in which the fund did poorly, investors ran for the exits. As the following chart shows, the fund surged 80% in 2007.

After the surge in price, the Wall Street Journal reported that investors poured $2.6 billion into the fund the following year, only to see the fund sink 48%. Investors then pulled more than $750 million from the fund in 2009.

Key Takeaway:

Investors tend to chase performance by investing after an investment does well and selling after it does poorly. This is the equivalent to driving a car only using the rear-view mirror.

If the annual 29% performance difference between the total return and average investor return does not convince you that investors are impatient and irrational, we can look to the results across all stock and bond funds for the last 30 years.

DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) produces this study on an annual basis. The DALBAR study showing the average annual returns for the 30 Year Period Ending 12/31/2021 reported the following gap between the returns of the average mutual fund investor and the returns of the mutual funds themselves.

Over the last 30 years, the average equity investor underperformed by 3.52% per year, and the average fixed income investor underperformed by 4.95% per year. Carl Richards coined the term “behavior gap” to describe the shortfall between investor returns and investment returns.

Investors have an uncanny, destructive tendency to buy high (when they’re feeling overconfident) and sell low (when they’re scared). According to DALBAR, “investor behavior is not simply buying and selling at the wrong time, it is the psychological traps, triggers and misconceptions that cause investors to act irrationally.”

Key Takeaway:

Investor behavior has destroyed investor returns across long time periods and asset classes. The behavior gap exists because rising prices attract investors and falling prices scare investors.

Why Do Many Investors Underperform?

If these human flaws that lead to subpar performance and market bubbles and crashes are consistent and predictable, can investors avoid them or ultimately take advantage of them? This is where behavioral finance attempts to explain how and why emotions and cognitive errors influence investors.

While the behavioral finance field has identified hundreds of mental mistakes, let’s explore three common mental mistakes that can harm investors.

Overconfidence Bias: Overconfidence bias is the propensity to misjudge our own ability and to believe that we are more capable than we actually are. Overconfidence typically is associated with an overly optimistic view of our own skills that often leads to blind spots in assessing our weaknesses and shortcomings.

Often overconfidence bias leaves us vulnerable to potential mistakes because it encourages us to be less cautious than we should be in our investment decisions. For investors, this causes them to think that they have the skills and knowledge to consistently beat the market. They believe they will succeed because blow ups don’t happen to them. This mental mistake was made clear in the story of Richard Fuscone.

James Montier in his research paper “Behaving Badly” conducted a survey of 300 professional fund managers, asking if they believe themselves above average in their ability.

Some 74% of fund managers responded in the affirmative. Most of the remaining 26% thought they were average. In short, virtually no one thought they were below average. These figures represent a statistical impossibility (Montier, 2006, p3).

Key Takeaway:

Overconfidence bias can be deadly in investing, as it often leads to investing in things the investor does not understand, using excessive leverage, and making position sizes too large.

Loss Aversion Bias: Loss aversion bias occurs when an investor becomes overly fearful and excessively concerned about avoiding losses that they are unable or unwilling to ride out the market fluctuations that are inevitable on the road to long-term success.

The more an individual experiences losses, the more likely that individual is to also experience loss aversion. Research on loss aversion shows that investors feel the pain of a loss more than twice as strongly as they feel the enjoyment of making a profit. As shown in the CGM Focus Fund example above, investors must fight their natural urge to panic and flea when their investments hit an inevitable rough patch.

Loss aversion can also lead to bad investment decisions such as not selling a losing investment. As legendary investor Philip Fisher wrote in his book, Common Stocks and Uncommon Profits:

“There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.” (Fisher, 1996, p 106).

Key Takeaway:

Investors feel twice as much pain from losing a certain amount of money as the pleasure they derive from an equal gain. This often leads to bad investment decisions such as not selling a losing investment.

Herd Mentality Bias: Herd mentality bias occurs when individuals make decisions based on what others are doing under the assumption that if everyone else is doing it, it must be correct. Individuals who fall into herd mentality bias are largely influenced by their emotions rather than by the results of their own research. This can often lead to investors getting sucked into the most overhyped stocks and sectors. It can result in massive bubbles which, when they burst, cost investors dearly.

Humans naturally herd. Think of the dotcom bubble or the recent meme stock craze. In both events, investors bid up the prices of companies that had poor or under-developed business models simply because everyone else was doing it.

There was no independent thought or analysis of the underlying company’s financial condition or future prospects. Rather there was a general consensus that investing in these companies was a can’t miss opportunity.

Unfortunately, what the majority believes to be true today, often is shattered by the reality of tomorrow. The most successful investors focus on observable facts rather than common opinions.

Key Takeaway:

Investors often follow the herd since it feels safer. This can lead to bubbles and subsequent crashes, costing investors dearly.

Conclusion

Investors, being human, often make financial decisions based on emotions and cognitive biases, rather than on rational and calculating analysis. These mistakes are a leading cause of asset bubbles and crashes and can result in investor underperformance.

Understanding and studying common mental mistakes, psychological influences, and biases can help investors recognize and avoid them, leading to better investment performance.

At Prairiewood, we have studied the behavioral finance field for years and strongly suggest that investors do the same. In addition, we have built our investing and wealth management process to avoid these biases. This includes developing an investment asset allocation based the goals and values of each client and then rebalancing back to those target percentages systematically and independently from emotional triggers.

If you are interested in having a Family CFO assist you in determining whether this structured approach could help you and your family make sound financial decisions, we would love to connect to see if what we do is right for you.

 

References:

1. Morgan Housel (2020). The Psychology of Money. Harriman House Ltd.
2. Philip A. Fisher (1996). Common Stocks and Uncommon Profits and Other Writings. John Wiley & Sons, Inc.
3. James Montier (2006). Behaving Badly. Dresdner Kleinwort Wasserstien – Global Equity Strategy. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=890563