On a suburban street, for example, homeowners who see their neighbours sell their houses for big profits are bound to want the same thing – that’s envy. The neighbours who have cashed in suddenly feel invincible, making them think they can correctly time the market again – overconfidence.
And both groups, in awe of a seemingly never-ending rising market, develop a myopic focus on the recent gains, rather than looking at historical averages – reliance on past performance.
Other studies have pointed to the phenomenon of comfort in numbers: Walking down a street, a passerby is more likely to choose a restaurant that has people sitting in the window than one that is empty, even though the quieter one could have better food. In uncertain situations, humans follow the lead of others, and at the very core, this is what happens in bubbles: People react to what everyone else is doing.
Another factor is the nature of regret: When we cash out an investment, our minds automatically calculate how much we could have made, theoretically, if we had kept riding the bubble.
Neuroeconomic experiments have showed that in bull markets, this fear of regret convinces people that they should invest more and more.
As the neuroscience guru Jonah Lehrer puts it, when we look at our handsome profits from investing 50 per cent of our portfolio, we quickly start to imagine how much money we would have made if we’d invested everything.
Then there is the danger that our brains, which are typically quite good at pattern recognition, sometimes overreach and see patterns that are not really there. This may be part of what is happening during a bubble.
The more complex the idea, however, the harder it is to prove with absolutely certainty. Even the most sophisticated behavioural economists will admit that it is almost impossible to be sure something like the restaurant effect is at play in a bull market.
Still, there is one theory almost no one disputes – the difference between thinking fast and thinking slow.
These terms were coined by Daniel Kahneman, a renowned behavioural psychologist and Nobel laureate, and explored in his recent bestselling book, Thinking, Fast and Slow: The “fast” system for decision-making relies on instincts and emotions; the “slow” one is more deliberate and analytic, but requires conscious, taxing effort.
Because humans are constantly inundated with overwhelming amounts of information, our fast systems have learned to make split-second decisions based on similar situations in the past. For the most part, this works out fine. But the human brain comes complete with some glitches.
“That’s sort of a necessary consequence of having a system that can do all kinds of other smart things,” says Scott Huettel, co-director of the Center for Neuroeconomic Studies at Duke University.
For example, the moon always looks bigger when it’s closer to the horizon than it does when it’s high in the sky – we are fooled by the context, although the moon itself hasn’t changed size.
But investors are loath to admit that there are limits to their rational abilities. Like a person in an emotionally charged bad relationship, humans are not willing to let go, because we too often believe that we are the exception – that we can make it work.
Mr. Kahneman came up with a name for this phenomenon: inside and outside views. With an outside view, a bunch of different items can be categorized based on their shared properties. With an inside view, certain items within the category appear to have unique traits.
An example is offered by Colin Camerer, a California Institute of Technology professor often regarded as the most important behavioural economist to emerge since Mr. Kahneman: While any marriage has about a 50-per-cent chance of surviving, try telling that to a newly married couple – they’re sure to believe their union is the one that will last.
Research in this area has discovered that is it particularly difficulty to adopt an outside view when ego is involved, when a lot of time has passed or when the issue is a personal matter.
All those characteristics are at play in bubbles: Ego is almost always a factor; investing your own cash inherently makes a bubble a personal problem; and the further back the last bubble was, the harder it is to see similarities.
There is an old saying in psychology departments: “People often question their eyesight or vision, but not their judgment.”
It’s different every time
The fact that people get caught up in economic bubbles over and over again may seem like a critical flaw in human evolution. But the real problem is that no two bubbles are precisely the same.