Stock market crashes and bubbles -- Why do investors never learn?

A. Srikanth

A CRASH of the financial market would invariably be followed by business newspapers with banner headlines and photographs of men, usually brokers, with dismayed faces or clutching at their heads.

But of late the stock market crashes have become so common place that such vivid picturing has become the subject of ridicule. Financial market players are no strangers to crises, bubbles, crashes, panics and manias. But why is that they still do not learn from the bitter experiences? Why should they, especially the investors, place themselves in such a situation and suffer? What causes such wild swings in share prices?

Is it possible to trace logically the wild movements to the fundamental shocks that affected the economy, industrial production and monetary policies. Or, are price movements due to psychological factors such as a change in investor confidence, speculative enthusiasm or herd behaviour.

Over the years it has been realised that the traditional explanations and modern finance and efficient market theory do not account for all of the market behaviour. The high volatility in the market, the crashes, the bubbles and the panics cannot be explained convincingly by the changes in just profits, dividends and valuation measures.

In fact, the financial community is finding it extremely difficult to explain the high prices and the high price-earnings multiple of software stocks through the conventional measures of dividends and profits. While the validity of the model itself is not being questioned, it is being argued that the existing model of efficient market is too restrictive to account for much of the volatility in the market.

As an alternative, financial economists are trying to offer explanations through what is called `behavioural finance'. Conventional finance and economic theory explanations of market activity assume rational behaviour on the part of the investors. On the other hand, the increasing number of crashes and bubbles is evidence of the fact that investors are rarely rational.

The growing area of behavioural finance offers explanations for the volatile market activity through the psychological theories of fads and fashions, diffusion of opinions, social movements, information cascades, herd behaviour, feedback trading, over-confidence and so on. Though a little abstract in its original form, financial economists are trying to formalise human behaviour into an experimental proposition.

The attractiveness of the alternative model is in its intuitive appeal. It is far more easier to reach out to the investors through their own psychological traits than through complex econometric and mathematical equations. Business Line has attempted to do just that through anecdotal evidences than through pure number crunching exercises.

Public memory is short

If we have to explain why investors do not seem to learn from their bitter experiences, we may probably have to delve deep into the patterns of human behaviour. This would be too complex an exercise. But it would suffice to say that public memory is short. Despite the severity of the some of the crashes and the panics, these events remain no more than faint memories in the minds of the investors. The environment is so dynamic that the details of the events, the mistakes and errors of the participants, are easily forgotten.

Each episode might appear different, though most have a common thread, so that the extent of learning is limited. The learning effect can also be limited as each episode of divergence from the fundamentals takes several years to assume bubble proportions. The Mississippi Bubble, the South Sea Bubble, the 1929 Crash, the Conglomerate Boom of the 1960s, the merger mania and the junk bond boom of the 1980s, the 1987 and the 1997 crash not only took time to develop, but were also years apart from one another. Prima facie, they are so different from one another that it is too difficult to draw a common thread.

Surveys subsequent to the 1987 crash throw more light; there were far more respondents to the surveys taken just after the crash compared to those taken quite some time after. The reactions of the investors too were more vivid and spontaneous compared to the delayed surveys.

Moreover, by the time a new bubble comes along, the old one is forgotten, or the market has a new set of investors who did not go through the previous one. A parallel can be found in the difficulty to explain the incumbency factor in elections or why the people elect a leader who was dumped on an earlier occasion.

Also, the people are driven by the oldest failing: Greed. As Charles Kindleberger writes in Manias, Panics and Crashes, there is nothing more disturbing than seeing your friend getting richer.

Fads, fashions and cultural issues

How do you explain the current craze for cell phones, laptops, discotheques, the Internet and other gizmos? Or, the hankering for branded consumer goods, fancy clothing, health food and fitness equipment? Why is going to the gym preferred to a brisk walk or jogging? All this represents changing fashions, cultural values, attitudes and people's mindset. But nothing much can be said about the causes for such changes.

This being the case, is there any reason to think that social movements do not affect the investment behaviour. The common thread running through these changes in fashion is the claim that people are sometimes excessively enthusiastic for certain kinds of speculative assets. At the height of the Tulip Mania, the urge among the public to possess a bulb was so high that all ordinary industries were neglected. On the 1920 Crash, G. K. Galbraith wrote that even the orthodox minority, which never went beyond Saint Thomas Aquinas and Marcel Proust, started talking about United Corporation and United Steel.

At the peak of the growth stocks mania, between 1959 and 1961, Burton Malkeil says growth stocks assumed such mystical significance that questioning their valuations was heretical. The sudden interest in the so called knowledge sectors of technology, Internet and bio-technology; the frequent shifts between growth and value stocks; the rise of mutual funds and the rise to fame of some obscure stocks of yesteryear are the more recent examples. It is possible to argue that investors base their decision more on the perception of the prospects for returns. But it is plausible that these perceptions of returns themselves represent changing fashions.

Group pressure

There is extensive experimental literature in psychology which explains how people are influenced more by others than by their own thinking. One such experiment is the `autokinetic effect'. The participants in this experiment were put in a dark room and asked to guess the extent of movement of a light source. In fact, the light source was not moving at all and the participants did not have any frame of reference in the dark room. Yet, the participants heard the answers of the others and arrived, without any discussion, at a consensus on the extent of movement.

Interviewed later, the participants had little awareness of the influence of the group on their judgment. Though individual participants are rational, the research showed how flagrant errors are possible under group pressure. The analogy can be used in investments too. The way investors reacted to share prices of software stocks, based on the reaction of others, is a case in point. The way investment tips spread through repeated mentions by newsletters, friends, newspapers and magazines is more evidence of group pressure.

Investment culture

The fads and fashions driving the market have been supported by the growing investment culture. Investor awareness in terms of knowledge about exchanges, trading procedures, investment techniques and so on has grown tremendously over the years.

According to a survey result put out by the New York Stock Exchange, the number of individuals in the US owning stock, either directly or through mutual and pension funds, totalled 69.30 million. In 1952, just 4 per cent of the population invested in the stock market. But by 1995, this had increased to 26 per cent; between 1989 and 1995, the figure had risen by 17 millions or 33 per cent.

The increase in price levels has been matched by a rising investor population. The latter is evidence of the fact that something other than re-evaluation of profits and dividends drove the bull market.

Natural inclination for gambling

The human mind naturally tends to gamble, and investment in shares has more than a fair share of the gambling element. In a survey conducted in the mid-1970s, investors gave an average score of 4.09 (on a scale of 1 to 5) to the statement, `I enjoy investing and look forward to more such activity in the future'. All other statements about the future prospects, profits and dividends got far lower scores.

Information cascades

Let them alone: they be blind leaders of the blind.

And if the blind lead the blind, both fall into the ditch.Many of the actions in the stock market, despite having a large following, often get reversed frequently. The recent switch away from the Net stocks in the US is an example. In other words, mass behaviour is often fickle. Why should an idea followed by a large body of investors crumble so easily? This is explained by the theory of information cascade.

Many tricky issues in the stock market are based on little information. But when the decisions made on the basis of so little information are imitated by other investors, an information cascade is created. That is, the initial weakness is spread over a large body of investors. Such investment ideas, even if they have a large following, are often fragile. Such investors are like the cat on the wall. Even if some new information comes in, suggesting that a different course of action is preferred, investor perception shifts as a whole.

The initial preference for value sectors based on little information and the subsequent shift to growth stocks are instances of such a phenomenon. But since the shift to growth stocks too is based on little concrete information, the market continues to behave like the cat on the wall and frequently shifts between the value and growth sectors.

Distilled wisdom

The mob is easily led and may be moved by the smallest force, so that its agitations have a wonderful resemblance to those of the sea. -- Publius Cornelius Scipio