Once a week.
Subscribe to our weekly newsletter.
Stock market bubbles: Our evolutionary roots explain why investors follow the herd
The same parts of the brain that help us navigate complex social interactions can also drive us to make wildly bad investments.
- Stock market bubbles, or asset bubbles, refer to a situation where stocks are valued far above what they're fundamentally worth.
- Unique factors contribute to each stock market bubble, but all play out in a generally similar series of stages.
- Research on the human social brain network offers insight into why investors participate in asset bubbles.
In retrospect, there were clear signs that the stock market bubble was about to burst in 2000.
The mid 1990s was a time of rapid technological growth and, consequently, wild speculation. Internet companies promised to transform the world. Dotcom stocks soared to incredible highs, with many multiplying in value shortly after initial public offerings, like Priceline, whose shares rose 1,000% just one month after going public.
But there were problems in 2000, ranging from a recession in Japan to the inevitability of the Federal Reserve raising interest rates. There was also the simple fact that most dotcom companies weren't profitable. In fact, many were in debt.
Some investors realized this but bought into the story that huge profits were just around the corner. They weren't. By 2001, most dotcom stocks had dropped at least 75 percent from their 52-week high, wiping about $1.75 trillion off the market.
But the dotcom bubble wasn't the first asset bubble to inflate and burst, and it wasn't the last. Unique factors contribute to each asset bubble, but all feature broad phases that are remarkably similar. And that's largely because of the strong psychological pulls of herd mentality.
The science of 'herd mentality' | Your Brain on Money | Big Think www.youtube.com
What is a stock market bubble?
A stock market bubble — or more broadly, an asset bubble — occurs when the price of an asset inflates far above what it's fundamentally worth. Like soap bubbles, asset bubbles inevitably pop, causing a sharp drop in price. Asset bubbles can occur in any market — including stocks, real estate, and commodities — and they've existed ever since people have been trading in markets.
One of the earliest and most famous examples is the tulip mania that occurred in 17th century Europe during the Dutch Golden Age. Tulip bulbs became so fashionable that prices rapidly soared, with some rare bulbs reaching prices that far exceeded the average annual income of Dutch workers. Then the market suddenly crashed in 1637.
Popping a bubble
To get a conceptual grasp on how bubbles form, imagine a high school party that gets out of hand. The party starts with a few people, maybe hanging out at a kid's house whose parents are out of town. A handful of other kids hear about the party and show up. Then word spreads among the whole class.
Afraid of missing out, carfulls of kids start showing up. Soon the house is packed with people. By midnight, a few wiser kids leave because it's getting out of hand. The party keeps raging. But inevitably, the cops arrive and bust the party. Some of the kids who stayed too late suffer the consequences.
In retrospect, it was clear that the party was going to get busted. So why did people stay? One reason is that, like stock market bubbles, it's impossible to predict exactly when the cops are going to show up — or, in other words, when collective emotions are going to shift from euphoria to panic.
In his 1986 book Stabilizing an Unstable Economy, the American economist Hyman Minsky gave a more technical description of how asset bubbles play out:
- Displacement: This phase occurs when some external force, such as a new technology, captures investors' attention. The dawn of internet companies is a good example: A handful of investors think the internet will be a game-changing technology, so they decide to invest early. Prices start rising.
- Boom: As more investors enter the market, prices rise at a quicker pace. The media starts covering the boom, which attracts even more investors, who fear that they will miss out on a great opportunity.
- Euphoria: Prices skyrocket to wild highs as investors throw caution to the wind. Although there are some pessimists (known as bears) criticizing the market, the optimistic investors (bulls) and analysts try to justify the inflated prices by touting questionable metrics and arguments. Some bulls say prices will never crash because the asset or asset class represents a "new paradigm" or because there will always be buyers waiting to gobble up any price drops, an idea called the "greater fool theory."
- Profit-taking: To lock in profit, a handful of "smart money" investors sell some or all of their asset holdings while prices are still high.
- Panic: Due to some kind of event, prices suddenly begin to crash. Euphoric buying turns to panic selling, which causes many former optimists to sell their holdings at any price, even at a loss. With essentially no new buyers showing up, prices drop even further because supply far exceeds demand.
Remember this old stock market bubble chart with all the stages explained? Well, I pasted the Bitcoin price chart o… https://t.co/mnBAvZnvF8— Peter Hamza (@Peter Hamza)1517510900.0
You can see these boom-and-bust cycles play out in markets throughout history, from tulips to Bitcoin. But what causes investors to keep inflating and popping stock market bubbles over and over again?
Conformity and the social brain network
Like other primates, humans are highly social creatures who model their behavior on what others are thinking, feeling, and doing. Over millions of years, the human brain has evolved to perceive social cues and use that information to strategically regulate our behavior. Social information is processed in multiple regions of the brain, which together make up the social brain network.
This network often helps us navigate social dilemmas. For example, if you're visiting a foreign country for the first time, and you're unsure of how to behave at, say, a religious site, you might copy the locals' behavior so you don't offend anybody and your visit goes smoothly.
But our tendency to copy others isn't always adaptive; sometimes the herd is wrong. What's strange, however, is that people tend to have a hard time recognizing when the herd is wrong, even when it's obviously wrong. No other psychological test illustrates this more clearly than the Asch conformity experiments.
In the 1950s, the psychologist Solomon Asch conducted a series of experiments designed to test how often individuals went along with a majority opinion that was clearly wrong. The original experiment went like this: Eight participants were asked to complete a perceptual task in which they had to look at a "reference" line on a card. Another card had three lines on it, one of which was clearly the same length as the reference line.
The participants were asked to say which of the three lines matched the reference line. In reality, all but one of the participants were actors. The actors were instructed to sometimes uniformly give the right answer but other times uniformly give the wrong answer. Over a series of rounds, the results showed that the non-actor individuals tended to agree with the obviously incorrect majority opinion, at least some of the time.
Interestingly, the psychological pull of conformity can even affect people who are familiar with the design of the Asch experiment, as Freethink's video shows.
"That intelligent, well-meaning, young people are willing to call white black is a matter of concern," Asch wrote.
One of the pairs of cards used in the experiment. The card on the left has the reference line, and the one on the right shows the three comparison lines.Fred the Oyster via Wikipedia
The members of Reddit's WallStreetBets community often call themselves "apes," a joke that refers to how they often "ape into" investments without giving it much thought or just because others are also doing it. It's a pretty accurate term when you consider how non-human primates make decisions.
To gain insights into the evolutionary roots of our own decision-making behaviors, researchers have trained primates like capuchin monkeys to trade coins for food and then studied how they spend the coins under various conditions. The results suggest that some primates seem to share several biases with humans, including:
- The endowment effect. Some primates seem to overvalue assets that are in their possession over ones that are not.
- Choice-induced preference changes. Some primates will shift their preferences to match their own previous decisions. For example, if primates rate two treats as equally desirable, but then are forced to choose between the two, they'll later devalue the treat they didn't choose.
- Loss aversion. Some primates avoid gambles that are framed as "losses" when compared to an arbitrary reference point. In other words, when given two trading options that pay the exact same amount, primates tend to prefer the option that frames their payout as increasing from an arbitrary starting point, rather than decreasing to the same payout.
But monkeys also exhibit another human bias when making economic decisions: conformity. Michael Platt, a neuroscientist and marketing professor at the Wharton School of the University of Pennsylvania, told Freethink:
"What we've found is that monkeys in a market where there's another monkey will tend to follow what that other monkey does. So monkeys tend to follow the herd. They copy each other, and they tend to buy, buy, buy. And they get into a bubble, and they lose everything."
Platt said the monkeys' behavior is funny, sure, but also profound because similar studies on humans yield the exact same results.
"That's really interesting to us, because it tells us that this behavior that we see in people — and that has enormous repercussions — it's there from a heritage that we share with monkeys going back 25 million years," Platt said.
Breaking from the herd
Our deep-rooted tendency to follow the herd is more of an evolutionary feature than a bug. We often benefit from following group signals, similar to a gazelle that takes off sprinting not because it sees a cheetah, but because it sees other gazelles sprinting.
Still, stock market bubbles reveal the dangers of blindly following the herd. So, how can people resist buying the top of stock market bubbles?
The answer might be to slow down. Although our social brain network enables us to quickly glean useful information from the herd, that speediness comes at the price of accuracy. Put another way: If you're consistently "aping in" on hype-driven stocks, you might make some quick gains, but you also might get caught holding the bag when the next stock market bubble bursts.
"In thinking about herding in bubble markets, I think it's reasonable to suppose that if we could slow people down, that would allow more evidence to accumulate, and more likely to make a better decision," Platt said.
Geologists discover a rhythm to major geologic events.
- It appears that Earth has a geologic "pulse," with clusters of major events occurring every 27.5 million years.
- Working with the most accurate dating methods available, the authors of the study constructed a new history of the last 260 million years.
- Exactly why these cycles occur remains unknown, but there are some interesting theories.
Our hearts beat at a resting rate of 60 to 100 beats per minute. Lots of other things pulse, too. The colors we see and the pitches we hear, for example, are due to the different wave frequencies ("pulses") of light and sound waves.
Now, a study in the journal Geoscience Frontiers finds that Earth itself has a pulse, with one "beat" every 27.5 million years. That's the rate at which major geological events have been occurring as far back as geologists can tell.
A planetary calendar has 10 dates in red
Credit: Jagoush / Adobe Stock
According to lead author and geologist Michael Rampino of New York University's Department of Biology, "Many geologists believe that geological events are random over time. But our study provides statistical evidence for a common cycle, suggesting that these geologic events are correlated and not random."
The new study is not the first time that there's been a suggestion of a planetary geologic cycle, but it's only with recent refinements in radioisotopic dating techniques that there's evidence supporting the theory. The authors of the study collected the latest, best dating for 89 known geologic events over the last 260 million years:
- 29 sea level fluctuations
- 12 marine extinctions
- 9 land-based extinctions
- 10 periods of low ocean oxygenation
- 13 gigantic flood basalt volcanic eruptions
- 8 changes in the rate of seafloor spread
- 8 times there were global pulsations in interplate magmatism
The dates provided the scientists a new timetable of Earth's geologic history.
Tick, tick, boom
Credit: New York University
Putting all the events together, the scientists performed a series of statistical analyses that revealed that events tend to cluster around 10 different dates, with peak activity occurring every 27.5 million years. Between the ten busy periods, the number of events dropped sharply, approaching zero.
Perhaps the most fascinating question that remains unanswered for now is exactly why this is happening. The authors of the study suggest two possibilities:
"The correlations and cyclicity seen in the geologic episodes may be entirely a function of global internal Earth dynamics affecting global tectonics and climate, but similar cycles in the Earth's orbit in the Solar System and in the Galaxy might be pacing these events. Whatever the origins of these cyclical episodes, their occurrences support the case for a largely periodic, coordinated, and intermittently catastrophic geologic record, which is quite different from the views held by most geologists."
Assuming the researchers' calculations are at least roughly correct — the authors note that different statistical formulas may result in further refinement of their conclusions — there's no need to worry that we're about to be thumped by another planetary heartbeat. The last occurred some seven million years ago, meaning the next won't happen for about another 20 million years.
A new episode of "Your Brain on Money" illuminates the strange world of consumer behavior and explores how brands can wreak havoc on our ability to make rational decisions.
- Effective branding can not only change how you feel about a company, it can actually change how your brain is wired.
- Our new series "Your Brain on Money," created in partnership with Million Stories, recently explored the surprising ways brands can affect our behavior.
- Brands aren't going away. But you can make smarter decisions by slowing down and asking yourself why you're making a particular purchase.
How Apple and Nike have branded your brain | Your Brain on Money | Big Think youtu.be
Brands can manipulate our brains in surprisingly profound ways. They can change how we conceptualize ourselves and how we broadcast our identities out to the social world. They can make us feel emotions that have nothing to do with the functions of their products. And they can even sort us into tribes.
To grasp the power of brands, look to Apple. In the 1990s, the company was struggling to compete with Microsoft over the personal computer market. Despite flirting with bankruptcy in the mid-1990s, Apple turned itself around to eventually become the most valuable company in the world.
That early-stage success wasn't due to superior products.
"People talk about technology, but Apple was a marketing company," John Sculley, a former Apple marketing executive, told The Guardian in 1997. "It was the marketing company of the decade."
So, how exactly does branding make people willing to wait hours in line to buy a $1,000 smartphone, or pay exorbitant prices for a pair of sneakers?
Branding and the brain
For more than a century, brands have capitalized on the fact that effective marketing is much more than simply touting the merits of a product. Some ads have nothing to do with the product at all. In 1871, for example, Pearl Tobacco started advertising their cigarettes through branded posters and trading cards that featured exposed women, a trend that continues to this day.
It's crude, sure. But research shows that it's also remarkably effective, even on monkeys. Why? The answer seems to center on how our brains pay special attention to information from the social world.
"In theory, ads that associate sex or status with specific brands or products activate the brain mechanisms that prioritize social information, and turning on this switch may bias us toward the product," wrote neuroscience professor Michael Platt for Scientific American.
Brands can burrow themselves deep into our subconscious. Through ad campaigns, brands can form a web of associations and memories in our brains. When these connections are robust and positive, it can change our behavior, nudging us to make "no-brainer" purchases when we encounter the brand at the store.
It's a marketing principle that's related to the work of Daniel Kahneman, a psychologist and economist who won the 2002 Nobel Memorial Prize in Economic Sciences. In his book "Thinking Fast and Slow", Kahneman separates thinking into two broad categories, or systems:
- System 1 is fast and automatic, requiring little effort or voluntary control.
- System 2 is slow and requires subjective deliberation and logic.
Brands that tap into "system 1" are likely to dominate the competition. After all, it's far easier for us as consumers to automatically reach for a familiar brand than it is to analyze all of the available information and make an informed choice. Still, the most successful brands can have an even deeper impact on our psychology, one that causes us to conceptualize them as something like a family member.
A peculiar relationship with brands
Apple has one of the most loyal customer bases in the world, with its brand loyalty hitting an all-time high earlier this year, according to a SellCell survey of more than 5,000 U.S.-based smartphone users.
Qualitatively, how does that loyalty compare to Samsung users? To find out, Platt and his team conducted a study in which functional magnetic resonance imaging scanned the brains of Samsung and Apple users as they viewed positive, negative, and neutral news about each company. The results revealed stark differences between the two groups, as Platt wrote in "The Leader's Brain":
"Apple users showed empathy for their own brand: The reward-related areas of the brain were activated by good news about Apple, and the pain and negative feeling parts of the brain were activated by bad news. They were neutral about any kind of Samsung news. This is exactly what we see when people empathize with other people—particularly their family and friends—but don't feel the joy and pain of people they don't know."
Meanwhile, Samsung users didn't show any significant pain- or pleasure-related brain activity when they saw good or bad news about the company.
"Interestingly, though, the pain areas were activated by good news about Apple, and the reward areas were activated by bad news about the rival company—some serious schadenfreude, or "reverse empathy," Platt wrote.
The results suggest a fundamental difference between the brands: Apple has formed strong emotional and social connections with consumers, Samsung has not.
Brands and the self
Does having a strong connection with a brand justify paying higher prices for their products? Maybe. You could have a strong connection with Apple or Nike and simultaneously think the quality of their products justifies the price.
But beyond product quality lies identity. People have long used objects and clothing to express themselves and signal their affiliation with groups. From prehistoric seashell jewelry to Air Jordans, the things people wear and associate with signal a lot of information about how they conceptualize themselves.
Since the 1950s, researchers have examined the relationship between self-image and brand preferences. This body of research has generally found that consumers tend to prefer brands whose products fit well with their self-image, a concept known as self-image congruity.
By choosing brands that don't disrupt their self-image, consumers are able not only to express themselves personally, but also broadcast a specific version of themselves into the social world. That might sound self-involved. But on the other hand, humans are social creatures who use information from the social world to make decisions, so it's virtually impossible for us not to make inferences about people based on how they present themselves.
Americus Reed II, a marketing professor at the University of Pennsylvania, told Big Think:
"When I make choices about different brands, I'm choosing to create an identity. When I put that shirt on, when I put that shirt on — those jeans, that hat — someone is going to form an impression about what I'm about. So, if I'm choosing Nike over Under Armour, I'm choosing a kind of different way to express affiliation with sport. The Nike thing is about performance. The Under Armour thing is about the underdog. I have to choose which of these different conceptual pathways is most consistent with where I am in my life."
Making smarter decisions
Brands may have some power over us when we're facing a purchasing decision. So, considering brands aren't going away, what can we do to make better choices? The best strategy might be to slow down and try to avoid making "automatic" purchasing decisions that are characteristic of Kahneman's fast "system 1" mode of thinking.
"I think it's important to always pause and think a little bit about, "Okay, why am I buying this product?" Platt said.
As for getting out of the brand game altogether? Good luck.
"I've heard lots of people push back and say, "I'm not into brands,"" Reed II said. "I take a very different view. In some senses, they're not doing anything different than what someone who affiliates with a brand is doing. They have a brand. It's just an anti-brand brand."
Powerful branding can not only change how you feel about a company, it can actually change how your brain is wired.
- Powerful branding can not only change how you feel about a company, it can actually change how your brain is wired.
- "We love to think of ourselves as rational. That's not how it works," says UPenn professor Americus Reed II about our habits (both conscious and subconscious) of paying more for items based primarily on the brand name. Effective marketing causes the consumer to link brands like Apple and Nike with their own identity, and that strong attachment goes deeper than receipts.
- Using MRI, professor and neuroscientist Michael Platt and his team were able to see this at play. When reacting to good or bad news about the brand, Samsung users didn't have positive or negative brain responses, yet they did have "reverse empathy" for bad news about Apple. Meanwhile, Apple users showed a "brain empathy response for Apple that was exactly what you'd see in the way you would respond to somebody in your family."