Day 3 - Greed and Fear - Making of a Bubble

Day 3 - Greed and Fear

The two most basic instincts of humans from the days of Adam and Eve. Adam was greedy and got tempted by the apple. And then fearful because he knew he would have to pay for his greed. 

These are our primal emotions. So then how do we get over them ? Each of us is emotionally wired differently. But as a crowd or mob our reactions are pretty much the same. I have a quote in my office by Charles McKay that says "Men think in herds, they go mad in herds. While they recover their senses, one by one."

And this is true from the 17th Century Tulip mania right down to the 2008 housing finance crisis. 

Now you may ask why does this cycle repeat itself when it is so evident. It repeats itself because with each cohort of older investors exiting the market, either because they have run out of financial or emotional capital or have passed away, a new set of younger investors enter the market. And these investors do not learn from the mistakes of the older generation because human beings like making their own mistakes. 

Now the name of the crisis or bubble may be different but the basic structure of a complete market cycle remains the same. Look at sketch below by Behavior Gap's Carl Richards. You can put the name of tulip mania, or gold rush, 1929 Great Depression, 1987 October Crash, the dot com bubble or the housing bubble or take your pick. It all fits into this one sketch.

And who better to illustrate this point with an example than Warren Buffett. In his testimony to the Financial Crisis Inquiry Commission he was asked. I have extracted this from an article in Fortune which you can read here

Brad Bondi [financial crisis inquiry commission]: What do you think it was, if you were to point to one of the single driving causes behind this bubble? What would you say?

Warren Buffett: My former boss, Ben Graham, made an observation, 50 or so years ago to me and he said, “You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”

After a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over. The price action takes over because people have forgotten the limitations of the original premise.

Now, we saw the same thing in housing. So this sound premise that it’s a good idea to buy a house this year because it’s probably going to cost more next year and you’re going to want a home, and the fact that you can finance it gets distorted over time if housing prices are going up 10 percent a year and inflation is a couple percent a year. Soon the price action -– or at some point the price action takes over. And once that gathers momentum and it gets reinforced by price action and the original premise is forgotten.

And the price action becomes so important to people that it takes over the—it takes over their minds, and because housing was the largest single asset, around $22 trillion. Such a huge asset. So understandable to the public—they might not understand stocks, they might not understand tulip bulbs, but they understood houses and they wanted to buy one anyway and the financing, and you could leverage up to the sky, it created a bubble like we’ve never seen.

The Internet was the same thing. The Internet was going to change our lives. But it didn’t mean that every company was worth $50 billion that could dream up a prospectus.

To summarise what is written above, incase you found it too long, Buffett is saying that the housing market demand was driven by a sound reason to buy a home because over a period or time it costs more to buy a home and if you are going to buy a home to reside in it then it better to buy early than later. However, as time passed genuine demand for housing began to taper off, but the supply of financing continued to be strong. And this caused housing prices to go up and at some time buyers were buying homes not because they wanted to stay in those homes but because prices were increasing at a rapid pace and cheap financing was available. And a sound investment premise became a bubble. The crossover point is known to none. And that's what makes it a market. 

No one is going to ring a bell at the bottom or the top of a market cycle because no one knows precisely where the market is going to make a top or bottom. But if you observe in a somewhat detached manner, you will know that what is going on does not make sense. But because we all suffer from FOMO (Fear of Missing Out), we jump in.

Tomorrow we will see what we can do to manage these two emotions.