The human flaws that drove this market crash and why they keep failing when we invest

People work at their jobs on the floor of the New York Stock Exchange on May 13.Courtney Crow/The Associated Press

Trillions of dollars invested in stocks and cryptocurrencies have evaporated since the tech sector sell-off began six months ago, and the last thing investors want to do is blame themselves. But if we are honest we must admit that we are all partly responsible, because once again our obsession with good stories is one of the main culprits.

Until now, rising interest rates have been a convenient scapegoat for those who suffer. Growth stocks do better when interest rates are low, and persistent inflation has forced central banks to reverse the market’s tailwind. by increasing the cost of borrowing.

But interest rates alone do not explain the change. What we are seeing now follows a pattern that was also present in each of the ugliest market crashes of the past three decades, including Black Monday, the dot-com crash, and the global financial crisis of 2008-09. In each and every one of those releases, our psychological flaws played a prominent role.

And now it’s happening again. It is painful to admit that we can be so foolish, because we have been burned before, but to believe anything else would be an absurd act of self-defense.

In a way, this shouldn’t be that surprising. A decade ago, behavioral economics became a popular field of study, because it helped explain the global crisis that had nearly driven our financial system into oblivion.

Unlike classical economics, which assumes that most people are rational when making financial decisions, behavioral economics combines psychology and biology to explain our actions. One of their main findings: We can be tricked into making some pretty dumb decisions, because we’re prone to character flaws like envy and overconfidence, which cloud our judgment.

Despite the widespread advancement of the field after the global financial crisis, behavioral economics has hardly been heard of during the pandemic. If anything, we went back to traditional models to understand the stock market rally that accompanied the spread of COVID-19. Yet the psychological forces were so powerful as market fundamentals in driving madness.

Summarizing these psychological influences can be misleading, because there are so many of them. Terry Odean, a leading professor in the field at the University of California, Berkeley, put it this way in a recent interview: “Nine times out of ten, maybe 99 times out of 100, people are willing to believe stories rather than numbers”.

Before COVID-19 emerged, modern investors had never endured a pandemic. Because there were no benchmarks, too many people began to believe exuberant stories about the possibilities of a digital economy. One of the most notorious stories was that in person everything was over: shopping, work meetings, even physical exercise.

We now know that this was wildly optimistic. Online shopping continues to account for about 20 percent of all retail sales in the United States, white-collar workers never want to hear the words “get on a Zoom” again, and Peloton only has a limited number of rich and athletes you can sell to. your Internet-connected exercise products. But the theory sure dreamed of nice for a long time.

The same goes for the cryptocurrency sector. Crypto companies were touted to retail investors as the future of finance, but now that we are returning to a somewhat normal way of life, it has been realized that digital currencies have few practical uses so far.

It’s too late for behavioral economics to tell us whether the bubble will burst, but understanding the field may offer some guidance on whether this correction will last.

In 2015, some leading researchers in behavioral economics drafted a set of principles to help explain the ways in which failures in our decision-making affect the way we invest. Among his findings is that the suffering inflicted by a loss is about twice as intense as the euphoria produced by a gain of the same magnitude. This helps explain why the recent correction looks so painful, even though the S&P 500 is still up 24% since the start of 2020.

Another principle, and one of the most succinct: “People have self-control problems.”

That may seem basic, because we know that to be true when it comes to other addictive behaviors, like smoking or eating unhealthy foods. And yet, by investing we convince ourselves that everyone who buys or sells stocks is making smart decisions.

We do it on the way up, because it’s painful to sit still when it seems like everyone is getting rich and we’re not. During a crash, we do it because no one wants to be the last to stand.

To be clear, no one knows how this fix ends up, and if someone tells you it does, don’t trust them. But here in Canada, we have a precedent that should serve as a guide for what is to come, at least for the sparkler sectors.

When cannabis stocks took off five years ago, his investment thesis was eerily similar to that of pandemic tech stocks. Investors thought they were entering the ground floor of the future.

No matter how ridiculous the valuations were relative to the actual numbers, such as the portion of the population that actually smokes weed or consumes edibles, investors were told, and happily believed, that Canadian cannabis companies were poised to dominate. the world.

It was the perfect test for behavioral economics. And we failed, spectacularly. Once the hype was exposed, the liquidation was relentless and did not stop until there was hardly any value left. Keep this in mind the next time someone tries to argue that a company that has never made any money is worth tens of billions of dollars.

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