The lesson from studying market history is how little human nature changes. In fact, the lesson goes beyond that. Human nature plays an important role in driving markets to extremes.
Throughout the years, a number of people have tried to explain the interaction between investors’ behavior and the stock market. John Maynard Keynes likened the stock market to a beauty contest.
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view… We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.
In other words, investors have skipped the part of picking the best stock or fund for the long run. And instead, they try to anticipate which stock or fund other investors think will go up the most.
John Kenneth Galbraith added the idea that markets lose touch with reality. Bubbles often start out with a sound premise but eventually the “rising prices” are all important.
For example, the 1929 Bubble began with the idea, published in Common Stocks as Long Term Investments, that stocks outperform bonds over time because companies retain a portion of their earnings to reinvest in their future growth. But that became less and less important as the market rose higher.
Speculation acquires a dynamic of its own. The factors behind the original revaluation of the asset are no longer important. What becomes important is the single fact that prices are rising. Because they are rising and money can be made, more and more people are encouraged to try and get a share in the capital gains. By doing so they keep prices going up. The original cause of the price rise eventually becomes the merest excuse for optimism.
Greed and fear of missing out push investors to chase what appears to be easy riches. Rising stock prices are all that matter.
George Soros expanded on the two ideas in what he called reflexivity. Soros first described this concept in 1973 after seeing it play out during the conglomerate craze in the late 1960s:
I look at the stock market as a historical process. I look at it as you would look at history. I don’t start with anything like fundamental values or equilibrium prices. I don’t think there is an equilibrium in the stock market. Otherwise it wouldn’t continue to fluctuate…
First, that people’s view of a situation in which they participate is always false. This is contrary to the view that the market is always right. I start with the assumption that the market is always wrong and that there is a divergence between the way people look at a situation and what the situation is. Second, there is a two-directional interplay between these subjective and objective factors.
In other words, people’s views of events influence events. The fundamentalists’ approach to the stock market takes a passive view and says that valuation is a reflection of values. What I’m saying is that you’ve got a two-way interconnection and that what people think has a bearing on what actually happens. This is true of history and it’s true of the stock market…
There can be two kinds of effect — self-reinforcing or self-defeating. In other words, if investors exaggerate something in one direction that has an effect on the underlying situation, that helps investors to exaggerate further. Then you have a self-reinforcing process. And self-reinforcing processes are the ones which can really give you a big move in the stock market. They also produce the historic changes. Not just divergences, not just swings of the pendulum, but situations where the fundamentals take charge.
He expanded on it further in 2009 following the housing bubble and 2008 financial crisis.
The reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium, not equilibrium.
The paradigm I’m proposing differs from the conventional wisdom in two respects. First, financial markets don’t reflect the actual economic fundamentals. Expectations by traders and investors are always distorting them. Second, these distortions in the financial markets can affect the fundamentals — as we see in both bubbles and crashes. Euphoria can lift housing and dot.com prices; panic can send sound banks tumbling.
That two-way connection — that you affect what you reflect — is what I call “reflexivity.” That is how financial markets really work… In short, the boom-bust sequences, the bubbles, are endemic to the financial system.
So reflexivity is a self-reinforcing feedback loop. Every new piece of information influences investors which influences stock prices which influences other investors and so on until it’s no longer sustainable.
The feedback loop that drives more and more investors to chase stocks as they rise to unsustainable heights, works in the opposite direction. Falling stock prices from investors selling stocks, influence other investors to sell, which hastens a market crash. In fact, one feedback loop sets the stage for the other’s inevitability.
Reflexivity provides a framework for thinking about how markets are pushed to extremes. And hopefully, it gives investors something to watch out for in order to avoid the common mistakes made in the next boom-bust cycle.
Sources:
The State of Long-Term Expectation
Stock Market Study: on Factors Affecting the Buying and Selling of Equity Securities
Lone Eagle, Barron’s 1973
Crisis is Endemic to the Financial System, NPQ 2009
Related Reading:
Buffett Explains Bubbles
Galbraith: Bubbles and the Bias Behind Speculation