Investing crazes and stock market bubbles are as much a part of human history as the evolution of trade. Market bubbles have plagued us since the 1720s, when the bursting of the South Sea Bubble and the Mississippi Bubble ruined so many investors that the British government outlawed the issue of stock certificates until 1825.
No matter how many tales of woe we are told of stock market bubbles ending in ruin, investors can’t seem to shake the lure of each new investment craze. What drives us to participate in investing crazes time and again? Perhaps the answer will guide us to better investing behaviors.
[Read: Are You Investing or Gambling in the Stock Market?]
Investing manias occur in times of economic transformation. Will Goetzmann, the Edwin J. Beinecke finance and management studies professor and director of the International Center for Finance at the Yale School of Management, has spent much of his career studying stock market bubbles.
His research has looked at every investing mania from the first ones recorded in the 1720s. He found they were all united by a common thread: the potential for fundamental innovation within the economy. “The periods where we’ve seen big transformative changes in the economy, or what appeared were going to be big transformative changes, we’ve also seen a lot of investment,” he says.
In the 1720s, that innovation was a monopoly on trade in the South Seas and the conversion of the monetary system from gold and silver to a paper currency by the Mississippi Co. In the 1990s dot-com boom, it was the evolution of the World Wide Web, and with bitcoin it’s the potential for a new way to transact business online.
People can’t resist the lure of new technology, perhaps to the greater economic good. Were it not for investors willingly putting their money into new technologies, we may not have the world we live in today, Goetzmann says. Imagine where we would be if nobody had been willing to take a risk on Amazon.com (Nasdaq: AMZN) in the dot-com boom? “The question is not whether you as an investor are smart to invest in new technology,” Goetzmann says. “The question is whether your investments are actually going to realize the economic benefit of these innovations.” This is something even the best and brightest investing minds struggle to do when it comes to new technologies.
If there are 10 companies offering a revolutionary technology, one or two could become Amazon or eBay ( EBAY), but eight will likely be busts. And absent a crystal ball, there’s really no good way to tell which ones will succeed.
If you want to invest in a mania, the best way to mitigate this risk is to limit your investment to 5 percent of your portfolio or less, says James Ragan, director of Individual Investor Group Research at D.A. Davidson in Seattle. This is important because investors often get captivated by the high potential return of an investment craze and forget about the risks involved — namely that they lose their entire investment.
We fall for the greater fool theory of investing. “A lot of people lack the patience to build a long-term investment strategy,” Ragan says. So when they hear about an investment generating 100-plus-percent returns compared to the 8 percent the market averages over the long term, they can’t resist.
[Read: The Best Ways to Value a Stock]
The trouble is the return potential of an investment craze often isn’t based on its intrinsic value. “With crazes people are just assuming there will be somebody willing to pay more for [their shares] in the future,” Ragan says. It’s the “greater fool theory of investing,” and it often leads investors to throw risk-return calculations out the window because how can you value a security based on what someone may or may not pay for it in the future?
We’re more afraid of missing out than losing. Peter DeMarzo, the Staehelin Family Professor of Finance at the Stanford Graduate School of Business in Palo Alto, California, says it isn’t that risk-reward calculations go out the window for mania investors as much as it is a redefining of their true risk.
He and his co-researchers, Ilan Kremer of the University of Warwick and the Hebrew University of Jerusalem and Ron Kaniel of the University of Rochester, found that what people care about most is not their own wealth alone but rather how their wealth measures up to that of their peers. “What I’m worried about as a loss is not an absolute loss; what I’m worried about is my loss relative to you,” DeMarzo says. “If you’re doing well and I’m not, that’s when I’m feeling loss.”
There are both psychological and economic reasons for this fear of missing out. If the people in your neighborhood are wealthier than you, that will drive up prices, making it harder for you to compete on an economic scale. This feeds the psychological fear that your peers might become wealthier without you. “So if you believe other people are making money in something, you want to jump in, too, even if it may not be rational to do so,” DeMarzo says.
Individual investors aren’t the only ones susceptible to this fear of missing out, either. Companies have also fallen prey to its allure. For example, banks fell into a similar relative-wealth trap during the financial crisis, DeMarzo says. Banks saw their peers making a lot of money in mortgage-backed securities and subprime mortgages and felt like they had to do the same to keep up. The end result was that banks all piled into a risky segment of the market, and we saw how that turned out.
[Read: 3 Steps to Forming an Investing Exit Strategy]
Will we ever escape stock market bubbles? As long as relative-wealth concerns are an important part of the human psyche, DeMarzo doesn’t think we can avoid getting swept up in investing crazes. “They’ll emerge anytime there’s something people perceive as a big potential windfall-type opportunity,” he says. At which point, the fear of missing out will inevitably pull them in again.
More from U.S. News
7 of the Best Tech Stocks to Buy for 2018
Avoid These 8 Rookie Investing Mistakes
8 of the Most Incredible Investments of the 21st Century
How Technology and FOMO Create Stock Market Bubbles originally appeared on usnews.com
