We all would like to think that we are smart people who make rational decisions. Much as we would like to believe that, we are mere humans driven by our social, emotional, and even cognitive factors that greatly influence our decision-making. But for now let’s just focus on our decisions on finance and investments. Simply by becoming conscious of these tendencies, we have a better chance of meeting our long-term investing goals. In the next series I will be covering various lessons to be learned emerging from the field of behavioral finance that may help you with your long-term investing success.
Herding Behavior: Is the concept that people are more comfortable investing their money in something that the vast majority of others are doing – relying on the wisdom of the crowd, even when the crowd is being a bit crazy.
Tulip Mania of 1600s
An example of such behavior was during the Tulip Mania of the 1600s in Holland. The Tulip, introduced in the early 1600s, was an unusual plant with its many varieties that had not been widely cultivated before then. The Dutch were so enamored of this unique flower that they not only bought them in droves but also began trading in contracts and investing in tulip bulbs for future seasons. In a lot of ways this is similar to investing in the stock of a company whose product you are convinced will only become more popular, the business more successful and hence the price of stock can only rise. Which is exactly what happened back then for the Tulip markets, making the price of Tulips and Tulip bulbs rise higher and higher, making investors earn more money overnight than the annual salary of a skilled worker at that time. But this was wealth created mostly on paper (at that time parchment) because who knows what something is worth until it is monetized. An amusing anecdote is recounted by Mackay that took place at the height of the mania. In what seems a complete loss of sanity of the people at that time, the bulbs were now deemed so valuable that (formerly) wealthy purchasers did not want to risk losing them by planting them, and so it became popular to display the plain bulbs in living spaces. In at least one instance the plan for safety backfired when a visiting sailor mistook a tulip bulb for an onion, and proceeded to eat it for breakfast.
People continued purchasing bulbs at higher and higher prices, intending to re-sell them for a profit to the wealthy from around the world. However such a scheme could only last until someone was ultimately unwilling to pay such high prices and take possession of the bulbs. And that is exactly what happened in one fine day in February 1637 when tulip buyers stopped showing up at the daily markets to buy these overpriced tulips or tulip contracts. Many extraneous factors such as the bubonic plague could also have had a role to play in the depressed demand for tulips. As this realization set in, the demand for tulips collapsed, and prices plummeted causing the speculative bubble burst. In the ensuing panic people tried selling their tulip bulbs and contracts as hastily as they bought them. However with few buyers, hordes of people (not herds) were left holding contracts to purchase tulips at prices now ten times greater than those on the open market (equivalent to todays expired call options), while others found themselves in possession of bulbs now worth a fraction of the price they had paid (equivalent to owning stock of a company which has declared bankruptcy i.e. market value of zero or close to zero).
So what can we learn from this? Well during an investing bubble it all makes sense – because everyone else is doing the same thing. But then after, investors ask the question – what were we thinking? This behavior has continued to the recent experience in the dotcom bubble and the housing bubble to name a few.
And what can you do? Work with a trusted Financial Advisor to create a customized investment plan to help provide the necessary diversification and the discipline to stay on track and avoid the fads of popular thinking while spotting the opportunities that others might have missed.
References: Mackay, Charles (1841), Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, London: Richard Bentley, archived from the original on March 31, 2008. http://web.archive.org/web/20080331091055/http://www.econlib.org/library/mackay/macExContents.html.
~Anita Srivastava is a Financial Advisor with Morgan Stanley Global Wealth Management in Ridgewood. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives.