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.
Information economics suggests that "no news" means somebody is hiding something. But people are bad at noticing that.
- An experiment in information sharing shows that no news often means people have something to hide.
- Other people seem to be blissfully unaware of this.
- The results suggest that market forces are insufficient to "close the information gap" between buyers and sellers.
A proverb that never seems to die is the oft-heard, "No news is good news." However, a new study published in the American Economic Journal: Microeconomics suggests that this not only goes against logic but also reduces returns in an information sharing game.
A marketplace for information
According to the principles of information economics, most firms have an incentive to release information on their products if the cost of doing so is low. The belief is that customers will treat firms that don't release information as being the same, so the one that does provide information — say, about the quality of the manufacturing — looks better in comparison for doing so. Over time, this should lead to more information being disclosed voluntarily as people try to cash in on the effect. An "unraveling" effect also occurs, with customers assuming the worst about those keeping secrets.
However, like a lot of ideas in economics, this one rests on the assumption that consumers will behave rationally or according to theory. Sometimes, people just don't catch on to the fact that some businesses might have an incentive only to reveal good news or to brush unflattering details under the rug.
To help shed light on how people actually behave and why they do so, the researchers set up an experiment based on an information sharing game where participants could win cash prizes for using information economics to their advantage.
An experiment in information economics
The main set of experimental sessions involved two randomly matched players, one as an information sender and one as an information receiver. The sender would be given a secret number between one and five by a computer. They then had a choice to reveal this number to the receiver or not. Lying was not allowed.
The receiver, who either saw the number or a blank space on their screen, then reported what they thought the secret number was. While the senders always saw and submitted whole numbers, receivers could guess any half unit between 1 and 5.
Sender players earned rewards as receiver guesses went higher, no matter what the secret number actually was. Receivers earned more for accuracy, with perfect determination of the secret number getting the most money.
The experimental set-up matches the theory; namely, the best "moves" are for the sender to always show the number unless it is one, and the receiver should always guess the number is one if they don't see a number.
Theory meets reality
But, things get muddy when theory meets reality.
After 45 rounds of play, senders tended to be between 3 and 7 percent off from the highest possible payouts, while receivers were 9 to 13 percent off. Numbers that you would expect to have been shown by the senders remained secret. Receivers made strange guesses, sometimes not trusting the values they saw (despite being told lying was against the rules) or guessing higher than they should have when shown a blank screen.
The authors mention that the receivers often seemed "insufficiently skeptical of nondisclosure" and failed to realize that the sender was probably hiding something from them. This effect could be somewhat mitigated by providing them feedback, though it had to be offered repeatedly for their improvement to be sustained.
They also opined that some receivers might have been confused by the rules of the game and played poorly as a result.
For the first time in a study like this, the researchers also asked the senders what they thought about the receivers. Their choices to reveal the number or not were often driven by a belief that the receivers would respond to not getting any information by guessing just below the middle of the number range rather than the lowest value as they should have.
As it turns out, they were right, with the average blind guess being above two. While the senders were not following the theory by acting this way, neither were their opponents — and thus, they were playing the game optimally.
It seems you really should play your opponent and not your hand.
Market forces are insufficient to close the information gap
The authors summarize the possible real world application of these findings in their report:
"These findings suggest that unless buyers receive fast and precise feedback about mistakes after each transaction, market forces can be insufficient to close the information gap between sellers and buyers. For the products that naturally offer such feedback — say cereals that taste crunchy and t-shirts that hold color fast — voluntary disclosure may converge to the unraveling predictions after a buyer purchases the product many times. However, for product attributes with less immediate feedback — such as the fat content of salad dressing and the cleanliness of a restaurant kitchen — voluntary disclosure may not converge to the unraveling results. In these situations, mandatory disclosure may be necessary if the policy goal is complete disclosure."
Oh, before you go, I promise that I didn't leave out any information from the study. Nothing important anyway.
These new status behaviours are what one expert calls 'inconspicuous consumption'.
In Veblen's now famous treatise The Theory of the Leisure Class, he coined the phrase 'conspicuous consumption' to denote the way that material objects were paraded as indicators of social position and status. More than 100 years later, conspicuous consumption is still part of the contemporary capitalist landscape, and yet today, luxury goods are significantly more accessible than in Veblen's time. This deluge of accessible luxury is a function of the mass-production economy of the 20th century, the outsourcing of production to China, and the cultivation of emerging markets where labour and materials are cheap. At the same time, we've seen the arrival of a middle-class consumer market that demands more material goods at cheaper price points.
However, the democratisation of consumer goods has made them far less useful as a means of displaying status. In the face of rising social inequality, both the rich and the middle classes own fancy TVs and nice handbags. They both lease SUVs, take airplanes, and go on cruises. On the surface, the ostensible consumer objects favoured by these two groups no longer reside in two completely different universes.
Given that everyone can now buy designer handbags and new cars, the rich have taken to using much more tacit signifiers of their social position. Yes, oligarchs and the superrich still show off their wealth with yachts and Bentleys and gated mansions. But the dramatic changes in elite spending are driven by a well-to-do, educated elite, or what I call the 'aspirational class'. This new elite cements its status through prizing knowledge and building cultural capital, not to mention the spending habits that go with it – preferring to spend on services, education and human-capital investments over purely material goods. These new status behaviours are what I call 'inconspicuous consumption'. None of the consumer choices that the term covers are inherently obvious or ostensibly material but they are, without question, exclusionary.
The rise of the aspirational class and its consumer habits is perhaps most salient in the United States. The US Consumer Expenditure Survey data reveals that, since 2007, the country's top 1 per cent (people earning upwards of $300,000 per year) are spending significantly less on material goods, while middle-income groups (earning approximately $70,000 per year) are spending the same, and their trend is upward. Eschewing an overt materialism, the rich are investing significantly more in education, retirement and health – all of which are immaterial, yet cost many times more than any handbag a middle-income consumer might buy. The top 1 per cent now devote the greatest share of their expenditures to inconspicuous consumption, with education forming a significant portion of this spend (accounting for almost 6 per cent of top 1 per cent household expenditures, compared with just over 1 per cent of middle-income spending). In fact, top 1 per cent spending on education has increased 3.5 times since 1996, while middle-income spending on education has remained flat over the same time period.
The vast chasm between middle-income and top 1 per cent spending on education in the US is particularly concerning because, unlike material goods, education has become more and more expensive in recent decades. Thus, there is a greater need to devote financial resources to education to be able to afford it at all. According to Consumer Expenditure Survey data from 2003-2013, the price of college tuition increased 80 per cent, while the cost of women's apparel increased by just 6 per cent over the same period. Middle-class lack of investment in education doesn't suggest a lack of prioritising as much as it reveals that, for those in the 40th-60th quintiles, education is so cost-prohibitive it's almost not worth trying to save for.
While much inconspicuous consumption is extremely expensive, it shows itself through less expensive but equally pronounced signalling – from reading The Economist to buying pasture-raised eggs. Inconspicuous consumption in other words, has become a shorthand through which the new elite signal their cultural capital to one another. In lockstep with the invoice for private preschool comes the knowledge that one should pack the lunchbox with quinoa crackers and organic fruit. One might think these culinary practices are a commonplace example of modern-day motherhood, but one only needs to step outside the upper-middle-class bubbles of the coastal cities of the US to observe very different lunch-bag norms, consisting of processed snacks and practically no fruit. Similarly, while time in Los Angeles, San Francisco and New York City might make one think that every American mother breastfeeds her child for a year, national statistics report that only 27 per cent of mothers fulfil this American Academy of Pediatrics goal (in Alabama, that figure hovers at 11 per cent).
Knowing these seemingly inexpensive social norms is itself a rite of passage into today's aspirational class. And that rite is far from costless: The Economist subscription might set one back only $100, but the awareness to subscribe and be seen with it tucked in one's bag is likely the iterative result of spending time in elite social milieus and expensive educational institutions that prize this publication and discuss its contents.
Perhaps most importantly, the new investment in inconspicuous consumption reproduces privilege in a way that previous conspicuous consumption could not. Knowing which New Yorker articles to reference or what small talk to engage in at the local farmers' market enables and displays the acquisition of cultural capital, thereby providing entry into social networks that, in turn, help to pave the way to elite jobs, key social and professional contacts, and private schools. In short, inconspicuous consumption confers social mobility.
More profoundly, investment in education, healthcare and retirement has a notable impact on consumers' quality of life, and also on the future life chances of the next generation. Today's inconspicuous consumption is a far more pernicious form of status spending than the conspicuous consumption of Veblen's time. Inconspicuous consumption – whether breastfeeding or education – is a means to a better quality of life and improved social mobility for one's own children, whereas conspicuous consumption is merely an end in itself – simply ostentation. For today's aspirational class, inconspicuous consumption choices secure and preserve social status, even if they do not necessarily display it.
The Sum of Small Things: A Theory of the Aspirational Class by Elizabeth Currid-Halkett is out now through Princeton University Press.
How will the current challenges to the global economy pressure it to change?
- Life is different everywhere—it is determined by the context of a unique culture and a unique geography. The same goes for economies. Local economies are unique to their contexts, says John Fullerton, founder and president of Capital Institute.
- "[I]magine if you thought about human economic development from a place-based perspective," says Fullerton. "You would have, instead of a global corporation like Apple, thought of as a single thing, you would have Apple's manufacturing plant in China as part of the Chinese bioregional economy."
- The pressure on the current global economy will cause it to shift and evolve into a healthier state of community-based economic development.
Economics professor Stephen M. Miller shares his insights in this exclusive interview.
- Stephen M. Miller, director of the Center for Business and Economic Research at the University of Nevada, Las Vegas, gives insight into how the COVID-19 pandemic impacts American economies.
- Calling it a "trade-off between public health and economic health," Miller explains why social distancing is a necessary measure to avoid a total crash of economies.
- The SIR model, which is a guide to assessing how much of the population is actively infected, shows what could happen if the active cases of infection goes above 10% of the population.
COVID-19 and the American economy
Photo by Maderla on Shutterstock
From non-essential businesses closing down to people experiencing temporary loss of work - what will the economic impact of this pandemic be in the near and distant future?
Stephen M. Miller, director of the Center for Business and Economic-Research at the University of Nevada, Las Vegas, agreed to chat with Big Think to answer some of the most pressing questions about how pandemics such as COVID-19 can impact the American economy.
COVID-19 - the trade-off between public health and the health of the economy
"The COVID-19 event caused a trade-off between public health and economic health," explains Miller. "In order to protect public health, governors felt it necessary to lock down their state's economies by closing down non-essentials and asking residents to go home."
This lockdown, according to Miller, is considered an adoption of nationally social-distancing regulations which has seen an instantaneous recession. He goes on to explain the risk of bankruptcy many small businesses are facing:
"The exposure [to facing bankruptcy] that businesses face depends on the liquid reserves they hold that they can use to survive a large loss of revenue from declining business activity."
While there is no way to tell just how deeply small businesses will be impacted, it will likely involve many small business closures.
What is the trajectory of COVID-19's impact on the economy?
Miller says that the effect on the American economy depends on the length of the pandemic. The longer COVID-19 lingers, the deeper the impact on the economy will be and the longer it could take for businesses and residents to recover.
What can people do to help the economy during these difficult economic times?
"People can follow the guidance of public health officials on social distancing and staying at home to solve the pandemic problem. The federal government has a big role to play in building bridges across the time the pandemic shuts down the economy, bridges for workers and small businesses so that the economy can take off again after the pandemic ends."
Can past pandemics give us an idea of what to expect about the short and long-term repercussions of COVID-19 on the American economy?
"This event appears to conform to the characteristics of the Spanish Flu in 1918-1919," explains Miller, "[That] pandemic killed 675,000 individuals in the US (0.8% of the 1910 population). Given today's population of 331 million, that translates into about 2.6 million deaths."
Miller further explains that our healthcare system and the structures in place to re-balance the American economy are much improved since the 1900s – however, our much-improved geographic mobility makes the transmission of a pandemic more problematic than it was in the past.
The SIR model
How can we estimate the damage caused to our economy from COVID-19?
Image by Ascannio on Shutterstock
The SIR model is a guide to assessing the spread of an epidemic in a population in which the total population is divided into three categories:
- Susceptible (S)
- Actively Infected (I)
- Recovered/Deceased (R)
How an epidemic pans out vastly depends on the transition rates between these three categories. According to recently published working paperecently published working paper by UCLA professor Andrew Atkeson, special attention will need to be given if the fraction of active infections throughout the population exceeds 1%. At this point, the health system forecast will be severely challenged.
Trajectory shows that if the fraction of active infections were to reach 10% or higher, this would result in staffing shortages for key financial and economic infrastructure, which could have devastating results.
The main conclusion of this paper is that the evolution of COVID-19 in the United States (and worldwide) will likely require social distancing measures to be maintained for an entire year or longer until a vaccine can be developed to avoid severe public health and economic consequences.
The economic costs of social distancing will be felt deeply across every state's economy as businesses close and employees are instructed to stay home, but the cost of a large cumulative burden of lost work time due to the disease further spreading could be much higher.