Investing

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The Cycle of Financial Manias: A Simple Explanation

One of the best things about reading history books, especially the financial side of it, is that you realize how not much has changed in how we behave when it comes to our money. And that is the reason financial bubbles keep happening, because human nature does not change.

Whether it’s the Dutch Tulip craze of the 1600s or the 2000s dot-com bubble, the global financial crisis, and the mania we are seeing in certain pockets of the stockmarket now, it seems we never learn.

But the more we study these past bubbles and manias, the better we can identify patterns in which they generally come to pass. This not only gives us insights into how such events are so hard to prevent, but also how we can prepare ourselves to deal with them better, without getting killed.

I recently explained to a friend, in a simple way, about the cycle of manias and human behaviour. Here is the chain of thoughts that we followed through, which may help you too if you are interested in understanding such a cycle, how it develops, and what happens ultimately.

First, What Creates a Financial Mania

1. It all starts with the exciting prospect of making money. When people see others getting wealthy, they join the action.
2. As people make money, they start to feel intelligent and competent. They think they have figured out a secret that others have not.
3. There is a common belief that wealthy people must be intelligent (look no further than your favourite social media account). This makes us trust the judgement of those who have already made money in the boom.
4. As more people buy in, prices go up. This seems to confirm that it is a good investment, attracting even more buyers.
5. Everyone seems to agree that this is a great opportunity. It becomes hard to question if it is really a good idea.

Second, What Leads to Its Fall

1. At some point, people realize that prices cannot keep going up forever.
2. Once this happens, or there is an external trigger (like central banks raising rates, or a health or socio-economic crisis), hell breaks loose. Everyone tries to sell at once. Prices plummet.
3. After the crash, people look for someone to blame. They do not want to admit they might have been foolish.
4. Instead of learning from the experience, people often focus on the wrong questions: What caused the crash? Who should be blamed?

Third, Why We Fail to Learn

1. It is hard to admit we were wrong or got carried away.
2. Many people believe markets are always right, making it hard to accept that sometimes they go crazy.
3. As time passes, we forget the pain of past crashes and get excited about new opportunities.
4. Each new mania comes with reasons why it is not like the previous ones.

Fourth, What Can We Do?

1. Remember that if something seems too good to be true, it probably is.
2. Studying past manias can help us spot new ones.
3. Try not to get caught up in excitement or panic.
4. Instead of following trends, try to understand the real value of investments.

While explaining all this to my friend, I also reminded him how the basics of human nature have not changed much for thousands of years. We are still drawn to the excitement of getting rich quick (and now also look down upon those who can’t). But when we understand the entire cycle of mania, then crash, and our failure to learn from the same, we can try to make wiser financial decisions and avoid getting caught up in the next big bubble, as and when it happens.

I left him with this passage from John Kenneth Galbraith’s book ‘A Short History of Financial Euphoria’ –

When will come the next great speculative episode, and in what venue will it recur – real estate, securities markets, art, antique automobiles? To these there are no answers; no one knows, and anyone who presumes to answer does not know he doesn’t know. But one thing is certain: there will be another of these episodes and yet more beyond.

Fools, as it has long been said, are indeed separated, soon or eventually, from their money. So, alas, are those who, responding to a general mood of optimism, are captured by a sense of their own financial acumen. Thus it has been for centuries; thus in the long future it will also be.

Investing, at its core, is a deeply personal journey. Yes, we operate within markets that are moved by collective actions and collective madness. But our individual paths to financial well-being are unique. If we remember this, by staying true to our own analysis and convictions, we give ourselves the best chance of surviving panics and manias, as and when they come to pass.

The crowd may sometimes seem to have wisdom. But more often than not, true investing wisdom comes from the ability to think independently, act rationally and, occasionally, to stand alone.

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What I’m Thinking

If your investments keep you up at night, it’s not your returns that need adjusting, but your investing strategy. True wealth is peace of mind.

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Letting the crowd’s optimism blind you to risks in investing…is one of the biggest risks you take as an investor. Beware.

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The wisest choices rarely feel good in the moment. True growth, personal or financial, requires living through periods of discomfort and delayed gratification.

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Quotes I’m Reflecting On

Holding cash is uncomfortable, but not as uncomfortable as doing something stupid.

– Warren Buffett

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What you should learn when you make a mistake because you did not anticipate something is that the world is difficult to anticipate. That’s the correct lesson to learn from surprises: that the world is surprising.

– Daniel Kahneman

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Favourable surprises are easy to handle. It’s the unfavourable surprises that cause the trouble.

– Charlie Munger

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That’s all from me for today.

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~ Vishal

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I’ve been reading Michael Mauboussin’s Think Twice: Harnessing the Power of Counterintuition over the past few days. It’s one of those books that makes you pause every few pages, look up from the text, and mutter, “Oh, I’ve been thinking about this all wrong.”

Among the sea of ideas Mauboussin has covered in his book, one idea that I have been thinking about deeply is the distinction between the “inside view” and the “outside view” in decision-making.

[Read more…] about Inside View vs. Outside View: A Critical Thinking Framework for Investing