Last week, as Bitcoin surged past $19k, I found myself genuinely contemplating adding to my crypto assets. My mind seemed to be drawn to the Coinbase app.
This is strange. I know that this impulse is misguided. Very misguided, in fact. I am well aware of why I shouldn’t have even been considering this action. I was even reading the excellent Devil Take The Hindmost by Edward Chancellor at the time, a history of financial speculation over the last 500 years or so. This book systematically catalogues the negative consequences of behaving as I was tempted to behave.
And yet…and yet I seemed drawn to that white C in the blue square in the bottom right-hand corner of my iPhone like a moth to a flame.
This is certainly not a new phenomenon and certainly not a new temptation. Financial speculation has been common since the Romans at the very latest and likely much earlier. From tulip-mania in the Netherlands in the early 17th century to the railway mania in Britain of the mid-1800s, to the stock market bubble of the roaring 20s in the US and crypto today, bubbles are common and seem to be getting increasingly more so.
There appears to be something innate either in societal structures or on a deeper humanistic level that makes people get drawn in. Something primal almost. Something very hard to avoid.
These bubbles have a kind of gravity: as the mass of investors in the bubble increases, the more those who haven’t invested are more likely to do so. These investors add to the bubble’s gravity, increasing its pull.
And it’s not just ‘suckers’ who get sucked in. The gravitational pull seems non-judgemental when it comes to the supposed intelligence of its victims: geniuses are also at-risk. Newton, who kindly provides us with the theoretical framework for this analogy, famously lost £20,000 (a substantial sum at the time) in the South Sea Bubble of the 1720s leading him to remark that “I can calculate the motions of the heavenly bodies, but not the madness of the people”. Einstein too, who improved on Newton’s ideas, allegedly lost significant sums speculating in the late 1920s crash. Applying your genius to the field of economics doesn’t seem to help either.
Keynes experienced heavy losses throughout the 1920s boom and Irving Fisher lost millions after claiming that “Stock prices have reached what looks like a permanently high plateau”. History is littered with these cases.
Professionals also don’t get a pass and are typically the most heavily invested in the bubble and, lack of skin in the game aside, most hurt by its popping. Although it wasn’t a bubble, there was something bubble-like about the Bernie Madoff Ponzi Scheme. It seems obvious that the returns couldn’t be maintained (easy to say in retrospect) and yet his investors included a whole host of reputable institutions such as HSBC and RBS.
Why does this happen? Why is there almost an inevitability about the existence of financial bubbles? Why, someone please tell me, was I so tempted to buy more Bitcoin?
We are fundamentally social animals. We care deeply (normal people do, at least) about things like what people think of us and our social standing. This seems to be an evolutionary consequence of living in tribes of no more than 100 people as hunter-gatherers.
Social interaction matters deeply in this type of environment as it’s vital for the survival of the tribe. Tribes that contained individuals with enhanced social characteristics were more likely to prosper and their genes were more likely to get passed on to future generations (us). That’s one possible explanation that seems plausible, anyway.
One consequence of this is herd behaviour. This is the idea that we have a tendency to copy the actions of those around us. The evolutionary logic being that if everyone else is doing something, it’s probably a good idea even if the reason for doing so isn’t immediately obvious. In hunter-gatherer societies, if all your mates start running in a certain direction but you don’t know why it’s probably best to start running anyway. It could be nothing but they could also be running away from a predator. If you don’t run, nothing happens or you get eaten. Non-runners tend to exit the gene pool under this mechanism. Hence, our species is composed of runners.
Applied to bubbles, if all your friends, all your colleagues and all the experts are investing in the bubble and talking about how great it is, we experience an incredibly strong desire to join them.
A manifestation of this evolutionary development is the Fear Of Missing Out (FOMO), which can be illustrated by the following scenario:
It’s Friday night, you’ve had a long day at work after a long week, a long month and a long year. All you want to do is go home, eat some tins of sardines and watch maths lectures on YouTube. You’ve been thinking about it all week, in fact. However, at 14:37 on Friday afternoon you get a Whatsapp message that sends chills down your spine: “Hey, what you doing tonight?”. You try and dismiss it straight away: “No, I’m not going out tonight, I’m knackered, I’m relaxing at home for sure.” you tell yourself. You don’t respond. You put the phone down…but you pick it up again 13 minutes later and look at the message again. You start to think. “What if this is a really good night? Ok, I’ll just find out what they’re doing.”
After discovering some loose plan that involves several different bars, the possibility of a house party and the promise that “Lucy is bringing all her mates from her hockey team” (spoiler alert – she’s not), you re-affirm that staying in is the best option. Phone down. Back to work. But there is something nagging at you. Something you can’t get out of your head.
What if this is an amazing night?
What if something crazy happens? What if John does that thing again? What if Lucy actually brings her mates from hockey?
You remember that amazing night a few years ago and how much you all still talk about it. You remember the look on your mate’s face who wasn’t there when the story comes up. You don’t want that to be you. “Fuck it”, you say to yourself, “I’m in”. FOMO has defeated you again.
Now transport this mechanism from the social world to the financial one. We are greedy and envious creatures. If your friends and getting rich, you certainly don’t want to miss out. The effect is actually more profound in financial spheres because wealth is a relative measure. All your friends getting richer is psychologically the same as you getting poorer. This leads to brutal FOMO and participation in bubbles.
Charlie Munger claims that “If you can work on incentives, you probably shouldn’t be working on anything else”. Although I wouldn’t go that far, he is correct to highlight the importance of incentives. They are absolutely vital to how society functions.
When considering financial bubbles, all the short-term incentives are to invest. From a financial perspective, you can make huge profits. Intellectually, you appear wicked-smart for investing in a rising asset, especially if you invested early. From a social point of view, you get a chance to feel part of the tribe and you avoid FOMO. There are no immediate incentives not to invest. There are actually disincentives of doing so: FOMO, peer-group-relative financial loss, intellectual doubt and insecurity, etc. Not participating is incredibly painful. The only incentive for not investing is long-term stability: you know you’re not going to take big losses with regards to the bubble asset. This incentive is weaker than a wet paper bag.
When the bubble bursts it doesn’t feel good, either. Everyone else is depressed and bragging about your non-loss is a bit of a social faux pas. It’s like being sensible on a Friday night and not drinking with your friends and being the only energised one the morning after: it’s not much fun if it’s just you. Think of the ending of the film The Big Short. Mark Baum and his hedge fund employees recorded huuuuuge profits but were depressed at the state of the economy in general. Celebrating by yourself isn’t really the same.
The incentives are particularly warped for professionals. Those who manage money have clients breathing down their neck, asking “Why did my friend make 34% last year and you’re only giving me 7%?!”. Everyone else is making 34%, so these managers will probably receive a lot of these types of enquiries. Clients may even start removing their money from the fund as a result. As Keynes said, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”.
This is compounded by moral hazard. Many who manage money have a “free option” in the sense that they receive some of the benefits of the financial upside of the money that they manage but a capped downside. The bankers and money managers get phat bonuses as long at the bubble continues to rise but lose nothing (well, maybe their jobs) when it bursts. Bad incentives if I’ve ever seen them.
Growth = Growth
We are patter-recognition machines.
We are extremely good at it. This is probably part of the reason we have prospered to the extent we have done as a species and a key ingredient in our learning process, if not the foundation of it (there’s a reason why many research efforts into AI are centred around it).
We are so good at it that we see patterns that aren’t actually there.
Take the price of bubble assets, for example. Our brain processes “the price has risen dramatically for the last 3 years in a row” and infers from this that “the price will rise next year”. A simple pattern, easy to recognise. But this pattern isn’t really there. Our brains are not adapted for financial markets and this is one way there are fooled.
This creates a feedback loop: as people apply this flawed reasoning and buy the asset which then rises in price as a result of this increased demand, vindicating their initial reasoning. The strengthens their conviction in the original conclusion (maybe they buy more of the asset). It’s a self-fulfilling prophecy.
Give us a good-enough story and patterns that are later validated and watch all attempts at evaluating intrinsic value fly out of the window quicker than a cheating neighbour.
My boy’s wicked-smart
You, yes I’m talking to you, think you’re smarter than everyone else.
People buy first and construct reasons for doing so after the fact. These reasons sound very reasonable in their own head. They also tend to have a plan for selling (which promptly gets forgotten/disregarded). People, yes I’m still talking about you, think they can out-smart the market (meaning other people) because, deep down, you think you’re smarter than the average person. You’re not. Not in a meaningful way and certainly not in a meaningful way within this context.
This over-estimation of our own intelligence is coupled with our over-estimation of the intelligence of ‘experts’. You assume that these people have studied said bubble market/markets in general/economics for decades, and must therefore know much more than you. This is true: they do know a lot more than you about the bubble asset. This is particularly acute when it comes to technological-based bubbles: the gap between your understanding and the understanding of the experts in these cases can be vast. Their reasons for price projections seem flawless (e.g. “the internet is the future so internet stocks will rise” circa 2000). You trust the experts. You invest.
However, they don’t really know a lot more than you about the price of the asset in the future. In mathematical terms, don’t confuse understanding of x (knowledge of the asset) with an understanding of f(x) (knowledge of the price of the asset).
In general, ‘dumb’ people are not as dumb as you think they are and ‘smart’ people are not as smart as you think they are.
When it comes to price projections of financial assets, these gaps are practically non-existent.
Eventually, financial bubbles burst. Usually, this is due to some kind of shock, typically associated with fraudulent/shady/illegal activity.
They reach a point at which there are no more ‘suckers’. No one else can be enticed to buy: instead of there being an excess of buyers there is now an excess of sellers. Everyone starts to realise that price greatly exceeds intrinsic value and they rush to liquidate their positions. As Nassim Taleb says, this is like everyone in a packed cinema rushing for the exit door at the same time. Pure chaos ensues as spreads widen, margin calls are activated, bankruptcy comes back into fashion and general financial ruin and loss is as common as the cold.
We have seen why not participating in these bubbles is exceedingly difficult but what’s the antidote?
Firstly, I find that an understanding of our past helps – read about the eventual ruin of the majority of bubble participants throughout history. Secondly, an understanding of how these bubbles function and why you are so tempted to invest is useful. You can stoically recognise your impulses objectively and not act on them, rather than your behaviour being driven by them.