“Quis furor, ô cives” – Lucan
“What madness was this, my countrymen?” This quotation was in Lucan’s civil war epic but is equally applicable to the craze caused by a financial bubble. Looking back on times where investor’s decisions making ability was impaired by a forming bubble, there is no other word that comes to mind than madness. This so-called mania is a product of investor’s susceptibility to decision making affected by biases. Investors revert back to simple beliefs or biases like correlation is causation, or it is easier to attribute success to skill, although luck was the only thing that affected their success. These biases send investors into crazes of overconfidence and constant self-attribution that are all traits investors attempt not to possess. The infatuation that comes over an investor throughout the time of a bubble is similar to that of the Botrytis Blight disease that inhabits the beloved Dutch Tulip. Biases play an important role in this obsession for a certain sector of the market for the duration of a bubble increase.
This fervor that creates bubbles normally begins with a Bull Market. A Bull Market is a market trend that encourages investors to buy stocks because of increasing share prices. The opposing market is called a Bear Market. Just as it sounds, it is a pessimistic market normally following a crash. Depending on the investor, they would be more inclined to buy shares in companies in one market rather than the other. Bear Market investors can be summed up in three quotes:
· “Be fearful when others are greedy, and be greedy when others are fearful,” says Warren Buffett, an investor, businessman, and CEO of Berkshire Hathaway.
· “Buy when there’s blood in the streets, even if the blood is your own,” says Baron Rothschild, a British banker.
· “Buy on the sound cannons, sell on the sound of trumpets,” says Nathan Rothschild, a London financier.
All of these quotes can recapitulate an expression by Bear Market investors around the world from William O’Neil to Jim Rogers or Richard Driehaus to Sir John Templeton, “Buy low, sell high.” Within a Bear Market, companies of high value are incorrectly assessed or reach a low point where the market does not display the value as clearly as it would in a Bull Market.
With a Bull Market, investors have a tendency to attribute their success to their smarts rather than the luck of the market going up. “Don’t confuse brains with the Bull Market,” says Author, Humphrey B. Neill. Neill is commenting on a common error that investors make: mistaking luck for skill or in more general terminology, correlation is not equal to causation in all situations. To back up Neill’s point, Duke University’s professor Emma Raisel states, “Your ability to make money in this environment is a result of a strong correlation with the overall market – it is not necessarily caused by your investing brilliance.” These Bull Markets are what help to increase two main biases, Over Confidence and Self-Attribution bias, and they are what lead to developing a bubble.
Tulipomania is the first bubble starting in 1634. It proves the power of trends and what how investors react to the market climbing. Since the 30-Year-War had just ended, and the plague was slowly being resolved, the markets in the Dutch Republic were becoming Bullish again. There was a labor shortage and wages were increasing, so the Dutch became more inclined to take risks. Little did they know the Dutch Republic was about to create the first financial bubble in 1634. Extraordinary Popular Delusions and the Madness of Crowds, by Charles Mackay, was published in 1841. It is a book about the studies of the psychology of crowds, specifically fallacies and delusions. Mackay says, “Until the year 1634 the tulip annually increased in reputation, until it was deemed a proof of bad taste in any man of fortune to be without a collection of them… A trader at Harlaem was known to pay one-half of his fortune for a single root, not with the design of selling it again at a profit, but to keep in his own conservatory for the admiration of his acquaintance” (89). At the beginning of the Tulipomania, the flower was seen as a rare and beautiful decoration or a gift for a loved one. French men would buy tulips for their wives as a present. Because it takes tulips seven years to properly mature, not only were the flowers valued, but they were in high demand and the supply simply could not keep up. The result of that was a steady increase in price. Merchants quickly became aware of this desire and saw it as an investment opportunity. Now, investors would buy the tulip bulbs hoping they could resell it at a higher price.
When the supply of tulips towers over the demand, the appeal decreases and the tulip is seen as less of a rare necessity. Consumers’ and investors’ interest in the tulip will then plummet leaving people penniless. With the tulip market increasing throughout the winter, many of the consumers would buy based on a painting or drawing they received that was a prediction of what the flower was going to look like. The deal would be made over a drink at the tavern and contracts would be signed. Many investors in the Tulipomania would go on to sell their contract within the same day of purchase to another buyer at a higher price. Since these deals were being made in the winter, two crucial things were going on that caused this bubble to burst. One, no money was exchanged nor were any bulbs until later in the year, which allowed the buyers to pay for the bulbs with money they did not have. Secondly, the florists were promising the consumers a flower that was not available yet. Suddenly, the supply surpassed the demand. When it became spring, there was no longer any desire to own a tulip that cost as much as their thirteen years pay. Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor was published in 2000. It focuses on the changes in investment psychology over the ages. Chancellor uses recorded proof of an anonymous pamphleteer from the Tulipomania times, “’if there should ever be more sellers than buyers, which given the number of people involved could easily occur, then the collapse of this mania will be at hand’” (19). On February 3rd, 1637, the whole market crashed. “There was no clear reason for the panic except that spring was approaching when delivery fell due and the game would be up” (19).
Throughout a “common bubble,” there is a motif of common fluctuations that occur. These shifts in the market cause investors to base certain decisions off of the assumptions they make about why the market is altering, otherwise known as biases. While the bubble is developing, it takes a while for it to build momentum. Once the media catches wind of the investment opportunities, the prices skyrocket. These shifts are pointed out by the graph. It points out where each type of investor buys into the stock and how it effects the market. Another way to represent how a typical bubble performs is with a quote by Sir John Templeton. He states, “Bull markets are born on pessimism, grow amid skepticism, mature in optimism, and die amid euphoria.” Relating his quotation to the graph, there are two main points of pessimism at the beginning of the bubble: Take Off and Bear Trap. From Media Attention to Enthusiasm and around the buildup to the First Sell Off, there is clear skepticism. Thirdly, the optimism of the public is most palpable from the Enthusiasm to the “New Paradigm!!!”. Finally, from the “New Paradigm!!!” to Denial and from Return to “Normal” to Fear exemplifies the euphoria an investor feels as the bubble is beginning to crash. There are many human biases that are fed all through the bubble’s maturing phases and others just as distinct in the downfalls of the bubble. Each phase of the bubble from Take Off to Return to the Mean exhibits an array of biases that cause investors to act as they do.
“Bull Markets are born on pessimism,” says Sir John Templeton. Pessimism is the mental attitude of seeing things with a lack of hope. Referring back to the graph, the main pessimistic phases are Take Off and Bear Trap. In most cases, investors have just come out of a small downfall or a turbulent market that they are recovering from. Once they are fully restored, investors have the habit of taking risks to gain back their wealth. “In the tulip, they found an object which enabled them to mix their love of display with the avid pursuit of wealth” (15). Tulipomania, as stated above, began after a large downfall of the economy. With wage increases and many job opportunities, the wealth was growing and so was the risk.
In the Take Off phase of Tulipomania three biases were shown: Belief Perseverance, Vividness, and Recency Effect. Belief Perseverance is the bias that given new contradicting information, one would maintain their belief despite the data. The tulips buyers knew they were buying flowers with money they did not have. They also knew the flowers they were buying currently did not exist. Even with this contradicting evidence of a definite collapse caused by nonexistent tulips and vacant wallets, the consumers kept buying, and the suppliers kept selling. Vividness and Recency Effect biases are similar. They describe the investor as recalling more knowledge about events that happened not long ago. As the investors of 1634 would most likely think of the past trepidation that occurred, and so they were ready for a prosperous, wealth filled future.
The Bear Trap phase of the bubble is the second aspect of the pessimistic advancement. Gambler’s Fallacy is the main bias shown by investors here. Gambler’s Fallacy is a mistaken belief if something currently occurs more frequently than normal, it will in the future begin to happen even less frequently. In gambling terms, if it constantly lands on red, a black is due. That, however, is false. Throughout the Bear Trap, an investor feels that since the market is at a low, a bump in the market is about to happen. In Tulipomania, the prices are at a constant increase, which means no Bear Trap occurs.
To be skeptical is to have doubts about something. If Sir John Templeton’s quote, “[Bull Markets] grow amid skepticism”, is accurate than in the very beginnings of all bubbles, investors are skeptical of the success of this sector of the market. They, of course, believe they are proven wrong when the attention builds, but many still remain skeptical. In the First Sell Off, investors doubt the company’s abilities to further grow and the market to increase to an even higher money-making point. Just like the Bear Trap, they are inclined to think with a Gambler’s Fallacy: The market is going up and up more than normal, therefore, a slight failure should occur. This creates motivation for them to sell their shares now before it crashes. When this happens, the prices plummet, causing the sector to fall into the previously described Bear Trap.
After the Bear Trap, the media picks up on the new stock(s) causing the enthusiasm to build. From the Media Attention phase to the “New Paradigm!!!”, there is a combination of John Templeton’s skepticism and optimism theory. A large number of biases are witnessed at this point of the bubble. Specifically, Media Attention causes the Frequency Effect, Recency Effect, Vividness, and Herd Behavior, but all of these biases are seen throughout the bubble’s escalation. Comparable to Vividness and Recency Effect, Frequency Effect is an Availability Heuristic stating that the more times you hear, see, encounter, etc. a company, the more likely you are to remember it. Although there was not Snap Chat, Instagram, or Fox News, for that matter, in 1634 Frequency Effect still existed. Tulip purchasing became a lifestyle for many Dutch people so one can imagine it was integrated in quite a lot of conversation. That filters into Herd Behavior. Herd Behavior is simply peer pressure. If the majority are investing in a company, it is more likely you are to follow along with them. When many people are participating in the reselling of tulip contracts, it becomes a common thing to do and many got dragged into it. Other biases that were common in the growth of the bubble are as follows:
· Self-Attribution Bias: An individual’s tendency to attribute success to personal skill and failures to something that was out of their hands.
· Sample Size Neglect: Inferring too much on a small sample of information.
· Status Quo Bias: An emotional bias stating that any change that happens from the baseline, status quo, is a loss.
· Causation for Correlation Error: “Your ability to make money in this environment is a result of a strong correlation with the overall market – it is not necessarily caused by your investing brilliance.” – Emma Raisel
· House Money Effect: When profits are earned, one is more inclined to take more and higher risks with that money.
· Overconfidence Effect: A person’s confidence in judgements relies upon more than other data or sources.
· Greater Fool Theory: “The bubble continues as long as the fools can find a greater fool to pay up for the overvalued asset” (800).
· Belief Perseverance: Given new contradicting information, one would maintain their belief despite the data.
· Ignorance: Relying heavily on current knowledge, so they do minimal research and make snap decisions to buy, hold, or sell.
· Endowment Effect: When an asset suddenly becomes your possession, the value, in your mind, increases substantially.
· Confirmation Bias: The act of favoring all data as a confirmation to a prior belief.
· Conservatism: Falsely reevaluating belief when new information is given.
· Money Illusion: Currency is nominally opposed to being real.
All of the other biases that went into the bubble boost of Tulipomania can be proved with one quotation from Chancellor’s book, “The average annual wage in Holland was between 200 and 400 guilders. A small town house cost around 300 guilders and the best flower paintings sold for more than a 1000 guilders. Against these values, we can measure the extravagance of tulip prices” (18). That gives an anchor for the information to come about the pricing of the bulbs. “A Gouda bulb of four aces rose from 20 to 225 guilders; a Generalissimo of ten aces, which had sold for 95 guilders fetched 900 guilders; a pound of plain yellow Croenen which sold for around 20 guilders rose in a few weeks to 1,200” (18). The price went from the equivalent of one month’s pay to five years. A craze to buy and resell these bulbs came over the Dutch. People would pay large sums of money to potentially obtain a tulip in the spring. “So anxious were the speculators to obtain them, that one person offered the fee-simple of twelve acres of building-ground for the Harlaem tulip,” says Mackay. The progression of love for these flowers grew so tremendously the Dutch paid two lasts of wheat (448 florins), four lasts of rye (558 florins), four fat oxen (480 florins), eight fat swine (240 florins), twelve fat sheep (120 florins), two hogsheads of wine (70 florins), four tuns of beer (32 florins), two tuns of butter (192 florins), one thousand pounds of cheese (120 florins), a complete bed (100 florins), a suit of clothes (80 florins), and a silver drinking cup (60 florins) for a single tulip bulb cursed with the Botrytis Blight disease that caused it to have fire like markings (2,500 florins).
At the peak of the bubble, the “New Paradigm!!!”, one huge bias shows up: Non-Regressive Prediction. Non-Regressive Prediction is the belief that a particular market will not see a correction. This means the market participants assume the market has changed and is not subject to a shift because it is a new type of market. Related to the Return to “Normal” phase, the public begins to believe this is the new economy they will live in. They think it will become a new normal for them. The graph shows this belief, in bubble situations, is, however, very false.
“Quis furor, ô cives,” says Lucan. The described madness that comes over every investor throughout the span of a bubble is caused by biases, an assumption made by someone attempting to explain the rise and downfalls of the market. These biases change an investor’s decision-making abilities due to common inclinations humans experience. They attribute luck for skill and the biases only augment from there. Investors react to bubbles in similar ways, whether it is the Tulipomania of 1634 or Cryptocurrencies of 2017. Biases influence the decisions of investors through the span of a bubble and causing them to come to a faulty conclusion.
Being the author of Early Bird: The Power of Investing Young, I might be a bit biased, but if you enjoyed this post make sure to check out my book.