Anatomy of a bubble

Chas Craig, BridgeTower Media Newswires

“As ‘bandwagon’ investors join any party, they create their own truth – for a while.”
–Warren Buffett, 2011 letter to Berkshire Hathaway
Shareholders

A recent column discussed two bubble prerequisites John Kenneth Galbraith identified in “The Great Crash 1929,” speculative mood and plentiful savings. Regarding speculative mood, Galbraith posited that far more important than the level of interest rates or supply of credit is a general sense of confidence that regular people are meant to be rich. With respect to plentiful savings, Galbraith observed that “If savings are growing rapidly, people will place a lower marginal value on their accumulation; they will be willing to risk some of it against the prospect of a greatly enhanced return.” While these prerequisites can help set the stage for a bubble, today we dive deeper to better understand the anatomy of a bubble.

In “Poor Charlie’s Almanack,” discussing the need for more reconciliation of psychology and economics, Charlie Munger cited a study by Colin Camerer of Caltech. In the study, high-IQ students, playing for real money, were caused to pay price A+B for a “security” they knew for sure would turn into A dollars at the end of the game. What follows is Munger’s assessment: “This foolish action occurred because the students were allowed to trade with each other in a liquid market for the security. And some students then paid price A+B because they hoped to unload on other students at a higher price before the day was over. What I will now confidently predict is that, despite Camerer’s experimental outcome, most economics and corporate finance professors who still believe in the ‘hard-form efficient market hypothesis’ will retain their original belief. If so, this will be one more indication of how irrational smart people can be when influenced by psychological tendencies.”

So, Camerer’s study shows that even when participants know with certainty that a “security” is worth A, a speculative bubble can break out into what is, in essence, a game of hot potato. Although the real world does not provide such clear-cut examples, the recent price behavior of “meme stocks” seems to be the best recent real-world analog to the Caltech study. I previously alluded to meme stocks (e.g., GameStop Corp.) in a recent column regarding the Dunning-Kruger Effect, which was initially introduced here in a late December 2020 column in which I drew parallels between poker and investing. The Dunning-Kruger Effect is a cognitive bias that predicts that the most ignorant people on a subject will be the least aware of their own ignorance and, therefore, will overestimate their ability in a given field.

Drawing a connection between the Dunning-Kruger Effect and the Caltech study, note that being ignorant on a topic (investing in this case) does not necessarily indicate that you are an individual with an unfortunately low IQ. In fact, the Caltech study specifically calls out that high-IQ students participated. It may follow then that those at the highest risk of falling prey to the Dunning-Kruger Effect are not those with low aptitudes generally, but those that are of generally high aptitude who have been professionally successful. For my own commercial interests, I will refrain from identifying exactly which professional groups I think are most at risk here.

However, it should be noted that even highly credentialed and experienced investment professionals are not immune to these sorts of psychological pitfalls. If this were not the case, the truly systemic bubbles of recent memory (i.e., the dot-com bubble of the late-1990s and the housing bubble of the mid-2000s) would not have been possible.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).