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Behavioral Biases That Lead To Asset Bubbles

Every few years, stratospheric prices give way to catastrophic asset bubbles. Every few years, we see stampeding herds of investors, armed with cash, powering through against all reason, fueling asset bubbles, shouting “this time it’s different, this time it’s different!”

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Ever wondered why asset bubbles never go away for good? One would assume that after decades of collective investing and trading experience, market players would’ve learned some lessons. Markets would finally be efficient, and assets would never trade above their fair values. But alas! Every few years, stratospheric prices give way to catastrophic asset bubbles. Every few years, we see stampeding herds of investors, armed with cash, powering through against all reason, fueling asset bubbles, shouting “this time it’s different, this time it’s different!”

The Roots of every Bubble

The roots of every bubble lie in two behavioral biases; these biases disrupt all models of efficient markets and make asset markets what they are; namely, sometimes rational, but most often irrational and inefficient. These are the “self-attribution bias” and the “hindsight bias”, respectively.

Fortunately for you, nobody’s holding a gun to your head and pressuring you to partake in the creation of an asset bubble. Markets have a short-term memory not dissimilar to Ghajini’s Aamir Khan’s! You, on the other hand, can consciously aim to build a longer term one. 

As Economist John Kenneth Galbraith so wisely noted: “there can be few fields of human endeavor in which history counts for so little, as in the world of finance”.  

The Self-Attribution Bias

When something in your life usually goes right, what do you typically attribute it to? Circumstance? Chance? The toil of another? Highly unlikely – most probably, you attribute the positive outcome to your own efforts or genius. It’s the same with investing; you may not know your stocks from your bonds - but if you’ve just made a winning investment, you’ll most likely attribute it to your own investing genius.

The self-attribution bias isn’t restricted to individual investors; wealth managers and portfolio managers are even more susceptible. I witnessed (and admittedly, experienced) some of it first hand as a rookie wealth manager in the early years of the millennium. As markets scaled glorious highs buoyed by liquidity and unwarranted optimism; even freshly minted, NFO flipping college grads transmogrified into genius financial advisers, attributing all the portfolio success of their clients to their own ability to pick the right stocks or funds. Most of these self-styled money wizards quickly vanished into oblivion post the carnage of 2008-09.

Similarly, we tend to write off bad outcomes to misfortune or somebody else’s follies. Investors do the same; all too often, poor investment performances are written away in the name of bad luck. While this may indeed hold truth at times, it’s more likely that it happened due to poor investment choices.

How do true market geniuses overcome the self-attribution bias? George Soros kept a diary in which he “recorded the thoughts that went into his investment decisions on a real-time basis”. That’s a terrific idea; by cross-referencing your decision-making process with the eventual outcomes, you can much more clearly understand where you were plain lucky or unlucky, and where your decision actually paid off or didn’t. This will help you refine your own investment strategies and principles over time.

The Hindsight Bias

Onwards to the hindsight bias, then. How often have you felt confident that “you knew it all along” after the occurrence of an event? You knew the NIFTY was going to crash in 2008 – at 28X P/E it just had to. But you queued in to buy at the peak nevertheless! Why?

The hindsight bias is at work here. This interesting little behavioral fallacy makes you believe that you knew it all along, after the actual outcome of an event. Thus, as we totteringly get back to our feet in the wake of a market crash, a plethora of ex-post analyses begin proliferating, making the event seem more predictable. The false sense of safety and confidence created thus, contributes to the ‘Ghajini’ style memory loss – until the next bubble, of course. 

The solution? The same as the previous one – a real time investment diary. When you make your next investment, pen down why you’re doing it, and after considering what risks. While you may initially be disappointed with the ineptitude of your investment decision making processes, you’ll come up the learning curve quicker and learn from your mistakes better. After all, Rome – and champion investors – weren’t built in a day.


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