It is tempting to explain bubbles as outbreaks of greed and foolishness: crowds of people who should have known better, swept away by the prospect of easy money. That explanation is comforting, because it suggests that sensible people would never be caught up.
The evidence suggests otherwise. Bubbles draw in experienced investors, professional fund managers, bankers, business owners and ordinary households who are careful in other parts of their lives. Many of them are not acting foolishly given what they see. They are responding to real evidence, real incentives and very human ways of thinking that serve us well most of the time but can lead us astray in a booming market.
This article looks at the psychological forces behind bubbles: how we extrapolate recent experience, follow others, grow overconfident, normalise high prices and forget past busts. It then suggests practical habits for recognising and resisting these forces, in investing and in business decisions. It is part of GoCore’s series on bubbles.
Extrapolation: assuming the recent past will continue
The most powerful force behind bubbles is extrapolation: the tendency to assume that recent trends will continue. If prices have risen 20% a year for three years, many people come to expect another 20% next year.
Extrapolation is not irrational in general. In many areas of life, recent experience is a good guide to the near future. Weather, traffic and the behaviour of people we know are all fairly predictable from recent patterns. But asset prices are different. Strong past returns often mean that prices have moved ahead of value, which makes future returns lower, not higher.
During the euphoric phase of a bubble, strong performance is extrapolated endlessly forward, and any consideration of fundamental value is swept aside. Surveys taken during booms commonly show investors and home buyers expecting returns far above long-run averages, often based on what they have just experienced.
Herding and social proof
People are strongly influenced by what others are doing. Psychologists call this social proof: when uncertain, we look to others for guidance. If friends, neighbours and colleagues are buying property or shares and making money, it seems reasonable to join them.
Herding has several sources:
- Information: if many people are buying, perhaps they know something you do not.
- Fear of missing out: watching others profit is uncomfortable, and the discomfort grows with every rise.
- Safety in numbers: if you are wrong along with everyone else, the consequences, including to your reputation, feel smaller.
- Professional incentives: fund managers and advisers are judged against peers, so following the crowd reduces the risk of standing out for the wrong reasons.
As a bubble develops, more and more people are drawn into speculation in the hope of making quick money. The market becomes a topic of everyday conversation. There is an old saying that when everyone, including people who have never shown any interest in a market, wants to buy, the end is near. The point is not that these newcomers are foolish; it is that their arrival suggests few potential buyers remain.
Overconfidence
Rising markets make almost everyone look skilful. An investor who buys during a boom and sees gains can easily attribute them to their own judgement rather than to a rising tide. This builds overconfidence: an exaggerated belief in one’s own ability to pick winners and time the market.
Overconfident investors trade more, take larger positions, borrow more and diversify less. They also tend to share their success. Part of the folklore of every boom is the newly confident investor boring friends with stories of their stock-picking skill, or the dinner-party conversation dominated by property gains.
Overconfidence is reinforced by a related bias: attribution. People tend to credit gains to their own skill and blame losses on bad luck. During a boom there are few losses to learn from, so confidence grows unchecked.
Normalisation of high prices
When prices first rise above previous levels, they seem high. After they have stayed there for a year or two, they start to seem normal. After several years, they become the reference point against which everything else is judged.
This normalisation is a form of anchoring: the tendency to judge values relative to a recent reference point rather than to an objective measure. During a bubble, people judge whether prices are permanent based on how long they have lasted, rather than on whether valuations make sense. Because bubbles can last for years, prices that are far above sensible valuations come to feel permanent and safe.
Normalisation also affects spending. Households whose homes or portfolios have risen in value for several years may adjust their spending to that new level of wealth, assuming it will last. The article Wealth effects explains how this can reverse.
Confirmation bias
Once people have committed to a view, they tend to notice evidence that supports it and discount evidence against it. This confirmation bias is especially strong when money and identity are involved. An investor who has bought into a booming market reads the optimistic analysis closely and skims the warnings. A homeowner whose property has doubled in value finds the arguments for continued growth persuasive and the arguments for a correction unconvincing.
Confirmation bias also shapes the information people seek. During a boom, optimistic forecasts, success stories and confident commentators are easy to find and pleasant to read. Sceptical analysis is less popular and less visible. People can end up in an information environment that reinforces their existing beliefs almost entirely.
Regret
Many bubble decisions are driven less by the hope of gain than by the fear of regret. People imagine how they would feel if prices kept rising while they stayed out, and that imagined regret can be stronger than the imagined pain of a loss. This is particularly powerful when friends and neighbours are visibly benefiting. Recognising that a decision is being driven by anticipated regret, rather than by analysis, is a useful moment to pause.
Fading memories
Bubbles typically develop after several years of strong economic growth, when the traumas of past recessions and busts, at least in that market, have faded. Each new generation of investors, lenders and borrowers may not have experienced the last bust directly.
This is sometimes described as disaster myopia: the tendency to underestimate the probability of rare but severe events as time passes since the last one. Lenders who have not seen large losses for a decade gradually loosen standards. Investors who have only seen rising markets underestimate how far prices can fall.
The appeal of a good story
Humans are drawn to stories. A compelling explanation of why prices are rising, a new technology, a new economic model, a growing population, is far more persuasive than dry statistics about valuation. The article “This time is different” explains how true stories can be stretched to justify any price.
Stories also spread. Media coverage, social media and everyday conversation amplify the most exciting narratives. Sceptical voices are less engaging and receive less attention, especially when prices keep rising.
Loss aversion and the bust
The psychology of the bust mirrors that of the boom. Loss aversion, the tendency to feel losses more strongly than equivalent gains, means that falling prices produce intense discomfort. Some investors hold on to falling assets, unwilling to accept a loss, hoping prices will recover. Others panic and sell at any price.
When fear spreads, herding works in reverse. Selling becomes the social norm. Prices fall far faster than they rose, in a kind of reverse speculation. Assets that everyone wanted become assets nobody wants, often at prices well below their long-term value.
Why intelligence is not enough
Knowing about these biases does not make people immune to them. Many of history’s most sophisticated investors have lost heavily in bubbles. Isaac Newton is widely reported to have lost a large sum in the South Sea Bubble of 1720 after selling early at a profit and then buying back in near the top.
The forces described here operate on everyone. They are features of how human thinking works, not defects confined to the careless. The practical question is not how to avoid being human, but how to build habits and systems that limit the damage.
Habits that help
Decide in advance
Write down, before buying or committing, why you are doing it, what you expect and what would make you change your mind. Written reasoning is harder to rewrite when emotions run high.
Use valuation, not momentum
Anchor decisions to measures of value, such as price compared with earnings, rents or incomes, rather than to recent price changes. The article Rising prices or a bubble? explains the main measures.
Seek out disagreement
Deliberately read and listen to people who disagree with the prevailing view. If you cannot find any credible sceptics, that itself is a warning sign.
Use rules for borrowing and concentration
Rules set in calm times, such as maximum debt levels or a maximum share of wealth in any one asset, protect against overconfidence during booms.
Keep a record
Records of past decisions, and how they turned out, counter the tendency to remember successes and forget mistakes.
Slow down
Many bubble-driven decisions are made quickly, under pressure, for fear of missing out. A deliberate pause, a day, a week or a month, often reveals that the opportunity is not as urgent as it seemed.
Bubbles in business decisions
The same psychology affects businesses, often outside financial markets entirely.
- Product fashions: businesses pile into a fashionable product category because competitors are doing so, without evidence of lasting demand.
- Technology adoption: organisations adopt a new technology because others are, rather than because it solves a specific problem.
- Expansion: owners extrapolate recent growth into ambitious expansion plans, assuming boom conditions will continue.
- Acquisitions: buyers pay inflated prices for businesses in a hot sector, encouraged by others doing the same.
- Hiring and pay: businesses compete for talent in a booming field, setting costs that only make sense if the boom lasts.
Recognising the same biases in business decisions is the first step to resisting them.
A worked illustration
This is an illustration, not a real business.
A small retailer notices that a new product category is booming. Competitors are adding it, customers are asking about it and social media is full of it. The owner feels strong pressure to commit heavily, ordering a large stock to avoid missing out.
Before deciding, the owner applies the habits above. They write down the reasoning: the product is popular, margins are good, competitors are stocking it. They ask what would change their mind: evidence that the trend is fading, or that customers buy once and do not return. They look for disagreement and find that some industry observers expect the category to become heavily discounted as supply catches up.
The owner orders a modest initial stock and sets a rule: reorder only if sell-through stays above a set level for two months. The category sells well for a while, then supply surges and prices collapse. Competitors who ordered heavily are left discounting large stocks. The retailer, with modest exposure, sells its remaining stock at a small profit and moves on.
Common mistakes
Believing only foolish people join bubbles. The forces involved affect everyone.
Using recent returns as a guide to future returns. Strong past returns often mean lower future returns.
Mistaking a rising market for personal skill. Gains in a boom are often the tide, not the swimmer.
Treating long-lasting high prices as proof they are permanent. Duration is not valuation.
Making major decisions under pressure. Fear of missing out is a poor guide.
Questions to ask
- Am I expecting recent returns or growth to continue simply because they have occurred?
- Am I doing this partly because everyone else is?
- Would I make the same decision if prices had not risen recently?
- What would change my mind, and have I written it down?
- For your own business: which current decisions are driven by a trend that could reverse?
Bringing it together
Bubbles are driven less by foolishness than by ordinary human psychology: extrapolating recent trends, following others, growing overconfident in rising markets, treating long-lasting high prices as normal, forgetting past busts and being drawn to compelling stories. In the bust, loss aversion and herding work in reverse, driving prices down faster than they rose.
Knowing about these forces is not enough to escape them. Habits help: deciding in advance, anchoring to valuation, seeking disagreement, setting rules for borrowing and concentration, keeping records and slowing down. The same habits protect business decisions about products, technology, expansion and acquisitions from the psychology of the crowd.
Sources: an introductory chapter on asset bubbles written in the mid-2000s, widely published research in behavioural finance, and documented market history. The worked illustration is hypothetical. This article is general information, not financial or investment advice.
