William Bernstein The Delusions of Crowds: Why People Go Mad in Groups

4 Signs of a bubble

1. Everyone around you is talking about it. And you should start worrying when people talking about getting rich in certain areas of the market don't have a background in finance
2. When people begin to quit their jobs to speculate in the markets
3. When someone exhibits skepticism about the prospects and people don't just disagree with them, but they do so vehemently. They usually say “You just don't get it.” “New Era” “It is different this time”
4. When you start to see extreme predictions.

• Human beings intuitively seek out outcomes with very high but very rare payoffs, such as lottery tickets, that on average lose money but tantalize their buyers with the chimera of unimaginable wealth
• Researchers have found that our brains fire not only with reward, but even more intensely with its anticipation.
  • There is nothing so disturbing to one's well-being and judgement as to see a friend get rich
• When presented with facts and data that contradict our deeply held beliefs, we generally do not reconsider and alter those beliefs appropriately. More often, we avoid contrary facts and data, and when we cannot avoid them, our erroneous assessments will even harden and make us more likely to proselytize them.
• People respond more to narratives than to facts and data. And the more compelling the story, the more it erodes our critical thinking skills
• We have 2 different types of thought process
  • System 1 or “reptilian brain” that is fast moving emotional response
  • System 2 or “evolutionary brain” that is much slower conscious reasoning
  • Our faster emotional machinery leads, and our slower “reason” follows
  • In a state of nature, the advantages of system 1 are obvious (IE – hissing snake at your feet). But in a relatively safe post-industrial world where dangers have a longer time horizon, system 1 dominance often occurs at great costs
• Bank supplied leverage is the fuel that powers modern financial manias and it has brought with it a roller coaster of bubbles and busts
  • Over the last 4 centuries, financial innovation has yielded a dizzying variety of investment vehicles: each, in its turn, was often simply leverage in a slightly different disguise and would prove the tinder that would set alight successive waves of speculative excess
• Bubbles typically end with a seemingly small disturbance, followed by a swift collapse
• Throughout history, property prices have ranged between five and twenty times annual rental values.
• When investors are unhappy with ultra-low interest rates offered on safe assets, they bid up the prices of risk assets with rosier potential income.
  • The allure of the hypnotic new technology (early 1800's railroads) was amplified, as is almost always the case with bubbles, by falling interest rates, which makes investment capital more plentiful
• Every bubble carry within it the seeds of its own destruction
• When compelling narrative and objective fact collide, the former often survives.
• Human beings suffer from confirmation bias, in which once they have settled on a hypothesis or belief system, pay attention only to data that supports their beliefs and avoid data that contradicts it.
• Hyman Minsky thought bubbles needed 2 conditions
  • Easy credit via low interest rates
  • Advent of new technology
• Investors excited about new technologies, or financial products, etc. begin to pour money into them. Since these assets can also be used as collateral for loans, rising prices mean that speculators can borrow even more to pour into these assets. A self-reinforcing cycle develops. But only on the way up
• Minsky developed the “instability hypothesis” which states that in a safe and stable financial environment, money inevitably migrates away from safe borrowers and toward risky ones. Eventually, things get out of hand, resulting in a blowup, which makes lenders and investors more prudent, and the cycle begins anew. Usually about once per decade
  • Amnesia is implicit in the instability hypothesis. After a crisis, investors shy away from risk. As markets recover and the unpleasant memories fade, participants become more open to risk and the instability cycle begins anew.
  • We all like a good story; in the grip of a bubble, when faced with the unpleasant or difficult calculation, a compelling narrative provides easy escape from the effort of rigorous analysis.
• Abandonment of hardheaded financial calculations in favor of compelling narratives is another factor that precipitates financial manias
  • Rather than attempt the nearly impossible estimation of the value of a stock with high projected future earnings (South Sea in 1720, RCA in 1928, Pets.com in 1999, or Tesla today) investors default back to the simple heuristic: “X is a great company and it is going to change the world, and its worth paying almost any price for it.”
• Humans have a recency bias: If stock prices have been rising for the past several years, they will come to believe that equity levels will continue to do so forever; as prices climb, shares become more attractive, which drives up prices even more. The reverse also happens during bear markets
• John Templeton “The four most expensive words in the English language are 'This time it's different.'”
• Max Winkler observed after the 1920 crash and discovery of the Dividend Discount Model that the market discounted not only the future, but the hereafter as well
• Debt can grow faster than the rest of the economy for so long before they implode
  • This is particularly true of private debt
• During bubbles, people become intoxicated by the pursuit of effortless wealth
• Even if we can't model bubbles, we know what they look like
• Minsky's amnesia requirement usually reveals a generational divide during bubbles; only participants old enough to recall the last boom and bust are likely to be skeptical. Their younger and more enthusiastic colleagues will deride them as old fogies
  • Bubbles are the province of young people with short memories
• Market Bubbles require 4 necessary conditions
  • Technological and financial displacement
  • Credit loosening
  • Amnesia of the past
  • Abandonment of time-honored valuation principles
• Under most circumstances, the Federal Reserve cares about 2 things
  • Overall state of the economy (as measured by GDP growth and unemployment)
  • Keeping inflation under control
  • Stock prices are of lesser concern and often wind up a bystander of the other 2 policies
• The Fed primary operates via the federal funds rate (interest rate at which member banks lend to each other overnight)
  • When interest rates on these are high, they attract investors. Which pulls investment from risk assets (stocks) and lowers their prices. The opposite is true
• We are apes who tell stories. When our remote ancestors needed to communicate with each other to survive, they did not do so with syllogisms, numerical data, or mathematics. The primary mode of that communication was and still is narration.
• Humans are narrative animals, no matter how misleading the narrative, if it is compelling enough it will nearly always trump the facts, at least until those facts cause great pain.
  • The more compelling the narrative, the more it erodes are analytical thinking
  • We also mold the facts to fit our preexisting opinion
  • We cling to facts that fit our narrative and ignore those that disconfirm them
  • We intentionally avoid exposing ourselves to contrary data
  • A compelling narrative can spread through a population just like a virus would and can even acquire critical mass
  • As more and more people share the same delusion, the more likely we are to believe in it, and so the more likely those around us will do so as well, a vicious cycle ensues, gaining more and more momentum until they finally smash into the brick wall of reality.