December 11, 2003
Why did so many buy into the 90s stock bubble?
Jane Galt looks at the stock market bubble of the late '90s and why so many supposedly bright folks lost their nest eggs. She proposes, in essence, that some nifty (in some applications) evolutionary programming overpowered our supposed rationality:
Seriously, think about the way evolution has programmed us to learn.There is a lot more so head on over and check it out.We are, by nature, fearful beings. But fear will only get you so far in this imperfect world, and so nature has also equipped many of us with a modicum of courage and a taste for novelty. Those people try new things. If disaster doesn't ensue, they try them again. If that works out, they do it a third time. Each time they lose a little more fear . . . and a few more, slightly less courageous people are encouraged to try it, having seen it work for the "thought leaders". After the eighth or twentieth repetition, the entire tribe is eating pterodactyl steak or riding railroads or investing in the stockmarket.
We are programmed to lose a little more fear every time we are successful -- to worry less about the risks. It's a heuristic that allows pre-rational animals to function pretty well in a universe of many unknowns.
But it has its costs. And I'd argue that speculative bubbles are one of them.
Rip Rowan thinks this article is interesting but not quite on the mark:
The problem with Galt's analysis is this: stock market bubbles are not irrational. They are perfectly rational responses to perfectly rational conditions.Hmmmm, pretty hard to make rational decisions with 'extremely poor information.' While the bubble itself may have been a rational response I think Jane's argument that "investors in the late 1990's had completely slipped their cams" is pretty solid.The rational condition is easy to understand: new, discontinuous technologies (for example, the advent of the Internet and new biotechnology possibilities opened up by the unraveling of the human genome) created an environment in which the market was forced to react to possibly revolutionary changes in the business environment with extremely poor information on the short- and long-term impacts of those technologies.
There are some additional comments on the article here, here and here.
Posted by Steve on December 11, 2003Steve wrote: "Hmmmm, pretty hard to make rational decisions with 'extremely poor information.'"
Disagree. It's hard to make safe or predictable decisions with poor information. But rational decisions are easy to make with poor information.
If I till you that you get $5 with every "heads" I flip and have to pay me $4 with every "tails" I flip, you can make a rational decision to take my bet, regardless of any prior knowledge of what the next toss will hold.
Likewise, if roll a 100-sided die, and tell you that with every 100 I will pay you $110, and with every non-100 you will pay me $1, you can also make a rational decision to take my bet.
All investing is based on imperfect information. When discontinuity occurs - such as with the advent of the Internet - investors are forced to make decisions with whatever information is available. As long as those decisions are based on a logical analysis of risk and reward, the decision is rational.
Were stocks overvalued in 1999? At the time it seemed uncertain. Now it's easy to see that they were. But of course, value is based on both long and short term expectations. In 1998, Amazon.com had yet to turn a profit. So it was quite overvalued. Yet, it would have been a good investment - it has quadrupled in price since then.
And - if you were an investor who, in 1998 decided to put your money into bonds instead of stocks because (in your view) stocks were becoming overvalued - you would have made a poor decision. They were not.
Posted by Rip Rowan at December 11, 2003 1:25 PM
