Salient to Investors:

Adam Nash at Wealthfront writes:

Author Edward Chancellor found bubbles contain two ingredients, uncertainty and leverage. In almost every bubble, some form of innovation or insight forces people to rapidly debate the creation of new economic value. typically compounded by a lottery effect, exacerbating early pay-offs for the first actors. In every bubble, some form of financial innovation broadly increases both leverage and liquidity.

The five obvious attributes of components of bubble psychology that play into market manias:

  1. Anchoring. We hear gold at $1,500, and immediately in the aggregate start thinking that $1,000 is cheap and $2,000 might be expensive.
  2. Hindsight Bias. We overestimate our ability to predict the future based on the recent past and over-emphasize recent performance.
  3. Confirmation Bias. We selectively seek information that supports existing theories, and we ignore/dispute information that disproves those theories.
  4. Herd Behavior. We are biologically wired to mimic the actions of the larger group, which can lead to self-reinforcing cycles of aggregate behavior.
  5. Overconfidence. We over-estimate our intelligence and capabilities relative to others. 74 percent of professional fund managers in the 2006 study “Behaving Badly” believed they had delivered above-average job performance.

People believe both that they are among the few who have spotted the trend early, and that they will be smart enough to pull out at the right time – “It’s different this time.”

In every bubble, some people do correctly identify the bubble, but the problem is that in every market, there are always people claiming that prices are too high – the cry of “bubble” is far more often proven wrong than right.

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