antidote for markets

What’s the Antidote to Market Euphoria?

Moving past anchoring, loss aversion, and herd behavior to financial education

What causes people to spend way too much on stocks?

It’s an interesting question, especially given the recent euphoria over the IPO of Snap, which I wrote about a couple times: “It’s Good to be an Entrepreneur” and “What Snap's IPO Can Teach You About Intrinsic Value”.

Writing for New Zealand Herald, Mike Taylor, CEO of PIE Funds, gave some helpful insight into the psychology of making money.

How much for that tulip in the window?

To set up how crazy investors can be, he uses a well-known story I’ve shared before as well, The Tulip Craze.

In a nutshell, between the years of 1634 to 1637, the price of certain varieties of tulip bulbs, an especially prized flower, grew exponentially. Things really heated up in 1636 to 1637. Alastair Sooke, writing for the BBC, gives an good account of what was happening:

One of the curiosities of the 17th Century tulip market was that people did not trade the flowers themselves but rather the bulbs of scarce and sought-after varieties. The result, as Dash points out, was “what would today be called a futures market”. Tulips even began to be used as a form of money in their own right: in 1633, actual properties were sold for handfuls of bulbs…In 1633, a single bulb of Semper Augustus was already worth an astonishing 5,500 guilders. By the first month of 1637, this had almost doubled, to 10,000 guilders. Dash puts this sum in context: “It was enough to feed, clothe and house a whole Dutch family for half a lifetime, or sufficient to purchase one of the grandest homes on the most fashionable canal in Amsterdam for cash, complete with a coach house and an 80-ft (25-m) garden – and this at a time when homes in that city were as expensive as property anywhere in the world.”…In early February 1637, the market for tulips collapsed…Demand disappeared, and flowers tumbled to a tenth of their former values. The result was the prospect of financial catastrophe for many.

We have our own Tulip crazes today

Lest you think a phenomenon like the Tulip Craze was a historical anomaly by backwards folks from hundreds of years ago, you need only to look at our own crazes in modern times like the tech stock bubble of the early 2,000s, the sub-prime crisis in 2008, and even the designer fruit craze in modern day Japan, where it can cost up to £20,000 for a square watermelon.

As Mike Taylor writes about these crazes, “At each instance, seemingly rational individuals have been affected by the herd mentality, and have bought and sold assets at prices that did not reflect fair value. Often, investors justify their decisions by saying they are in a new paradigm and the current set of circumstances are set to continue forever. The reality is usually far from that - in fact, quite the opposite.”

Today, we may be facing another craze in stocks. In fact, since it’s lowest point during the Great Recession, the S&P 500 grown 194%. The Dow is no slouch either. It’s up 201% since it’s lowest point. It’s been a seven-year bull market, and the euphoria doesn’t seem to be stopping. Even Warren Buffett, the most-famous investor in the world, seems to think, “stocks are actually on the cheap side.

Three factors in market euphoria

Most investors today think that the fun will continue. They firmly believe as Taylor writes that “they are in a new paradigm.” Taylor gives three reasons for this mindset:

Anchoring: This is a trait where an investor will "anchor" to a price that is important to them, but may have no relevance at all to the market they are investing in. For example, being focused on doubling your money, and only selling an asset if or when the price reaches this point.

Loss aversion: Recognising a loss is uncomfortable for most people and investors will try to avoid it where possible. That means that if an asset is below the price the investor paid for it, they are prepared to wait in the hope they will get back to break-even. This can prove disastrous if the asset is in terminal decline. At best, it means your capital is stuck in a poorly performing asset when it could be reallocated elsewhere.

Herd behaviour: From a young age, we learn to succumb to peer pressure as the path of least resistance. When it comes to investing, we take comfort if everyone else is doing the same thing. For example, if everyone is buying over-priced internet shares, even if your rational brain tells you this is madness, you justify your decision because, "all my friends are doing it and they are making money, so it must be OK".

Surely, Buffett understands how to avoid the three behaviors Taylor lists. As one of the richest men in the world, he doesn’t get sucked into the euphoria of the markets. He only profits from them. How?

The important caveat from Buffett is that his determination that stocks look cheap based on the current environment of low interest rates. "If interest rates were seven or eight percent, these (stock) prices would look exceptionally high," he said. And of course, by all appearances, interest rates will continue to rise.

Why financial education is a must-have to survive

Unfortunately, the average investor doesn’t understand the fundamentals of the markets, let alone how interest rates impact the value of stocks. They just buy because the market is going up…and everyone else is doing it.

And this brings up an interesting question. What’s the antidote to anchoring, loss aversion, and herd behavior?

The answer is found in financial education.

By understanding how money and markets work, you are better equipped to see the trends happening…and profit from them. Buffett has built his fortune doing just that. And so have I.

If you want to up your financial education, a good place to start might be these “15 Must Have Financial Education Lessons to Gain True Financial Literacy.”

But you have to go deeper than that.

For instance, if you were interested in stocks, you’d benefit greatly from studying under Rich Dad Advisor, Andy Tanner. He can teach you to invest like Buffett—not like the average investor. Hint: it’s a lot more complicated than buy, hold, and pray.

I still believe the biggest stock market crash in US history is looming. I also believe that, with the right financial education, you can thrive while others struggle to survive. All it takes is moving past things like anchoring, loss aversion, and herd behavior to truly understand how money works…and how to make it work for you.

Original publish date: March 28, 2017

Join Our Community—1.5 Million Strong

Register for free!