Many of the bubbles of recent years that are not shown in the tables were in dollar terms as large as or larger than some of the stock market bubbles shown.

As Table 1-2 also indicates, the dominant trend displayed in the six stock market bubbles since the 1960s is the increasingly prominent role of technology-related stocks, culminating in the infamous dot-com bubble of 1996–2000, by far the biggest technology bubble to this time. Technology stocks have had a special allure. Everyone had a general idea of what a big win IBM had been. It made over 11,000 percent on a buyer’s original investment from 1945 to 1968 and was still growing. Why not buy the next IBM now? The promoters—oops, investment bankers—spun out thousands of new technology issues for buyers to snap up. Computer-leasing companies, for example, could quadruple or quintuple the money they made, buyers were told, by simply purchasing computers from IBM and leasing them at a lower rate. Leasco Data Processing Equipment Corporation and Levin-Townsend Computer Corporation made billions of dollars for their owners and the investment bankers before they went bust. Ten years later, most of those would-be IBMs had collapsed.

In a bubble any torrid concept will work. Investors in each mania have believed and followed pied pipers. One led them dancing to National Student Marketing Corporation (NSM), the hottest stock of the go-go market of the late 1960s. At one time it traded at nearly 100 times earnings because NSM promised to unleash the collective marketing power of hundreds of thousands of college students. What it could actually market—and how well—wasn’t known. The “power” of NSM’s “massive” marketing force consisted of maybe seven hundred part-time college students at its peak, but the story sounded believable, so the stock rose as high as $143 a share before reality kicked in. Then the share price dropped, like a bear on a 150-foot bungee cord, to three and change. But it didn’t spring back.

Contemporary Crashes More Severe

So there are remarkable similarities in market bubbles, but there is also one important difference in the most recent booms and busts. Holland, France, and England were still prosperous after their bubbles imploded. Many speculators lost their homes, their businesses, precious metals, and other valuable assets, but the countries’ economies remained strong and continued to grow stronger as the years passed. The bubbles from the 1960s to the early 1990s, although high for any period, also did little longer-term damage to the economy; the nation continued to prosper and grow. However, the last two bubbles in Table 1-2 are a very different species. Not only have more recent bubbles occurred much more frequently; they have also caused more damage. The dot-com bubble and crash of 1996–2002 is estimated to have cost investors $7 trillion and forced millions of people of retirement age to continue working because of major losses in their pension plans.

The enormous loss of wealth was also due to keeping interest rates far too low for much too long under first Chairman Greenspan and then Ben Bernanke, his successor at the Fed. This disastrous policy was instrumental in setting up the recent financial crisis, which is estimated to have caused losses of $25 trillion to $30 trillion in security values alone. Added to the cost were lost GDP, lost employment, and other major charges that brought the total loss much higher. We can also see that losses in contemporary manias are as high as and sometimes considerably higher than in those in centuries past. The price of South Sea Company stock appreciated 720 percent to its peak, while the price of tulips ran up 1,500 percent. The price of Qualcomm stock, by comparison, skyrocketed over 22,000 percent to its high, Yahoo! 18,000 percent, and Amazon.com 7,500 percent. Dozens of other dot-com stocks appreciated several thousand percent.

And all of this happened despite the fact that investors were the best educated in history. They commanded powerful state-of-the-art computers and instant communication and had up-to-the-nanosecond data at their fingertips, as well as the finest research money could buy. All the tools of logical decision making were better than ever; only the outcomes were among the worst on record. All of this is why gaining a better understanding of the psychology of both investors and the market is so crucial. The psychology of investors’ overreaction is only now being researched in detail by scientists in the fields of cognitive psychology and neuroeconomics, and the work is providing new answers about why and how bubbles take place and, importantly, how the same forces that generate bubbles influence our investment decisions in any kind of market. This research has added greatly to the basic appreciation of the irrationality of investors’ behavior popularized by some very astute pioneers.

Understanding Bubbles: The Early Years

Far from faddish, modern psychological insights applicable to market behavior have grown over 170 years. One of the first steps of scientific method is accurate observation. This is as true in psychology as it is in chemistry, medicine, or other scientific fields. As far back as the 1840s, the Scottish journalist Charles Mackay used his astute powers of observation to develop the antecedents of behavioral finance. He wrote a remarkable book, Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841 and still in print.

Mackay examined the three historic bubbles we have discussed—the Dutch Tulip Mania (1630s), the English South Sea Bubble (1720), and the French Mississippi Bubble (1720)—as well as other instances of crowd madness from alchemy to the burning of suspected witches and sorcerers at the stake. He declared, “We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it. . . . Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. . . . Men, it has been well said, think in herds . . . go mad in herds, while they only recover their senses slowly, and one by one.”4 The characteristic he observed repeatedly was that when the enormous surge of speculative enthusiasm ends and the bubble begins to implode, the crowd becomes as extreme in its panic as it was euphoric. Caution and rationality are lost in the stampede to sell. In a market collapse, terrified investors are oblivious to fundamental value, just as they were when no price was too high to pay.5 Mackay captured the flavor of mania and panic as well as any writer to this day.

Picking up from Mackay, Gustave Le Bon wrote The Crowd: A Study of the Popular Mind, published in English in 1896. Le Bon was a French social psychologist, sociologist, and amateur physicist. His book brilliantly caught the actions and moods of the crowd that Mackay had described. Le Bon wrote, “The sentiments and ideas of all the persons in the gathering take one and the same direction. . . . A collective mind is formed . . . presenting very clearly defined characteristics. The gathering has thus become . . . a psychological crowd.”6

A most striking feature that Le Bon noted was a crowd’s inability to separate the imaginary from the real: “A crowd thinks in images, and the image itself immediately calls up a series of other images, having no logical connection with the first. . . . It accepts as real the images evoked in its mind, though they most often have only a very distant relation with the observed fact. . . . Crowds being only capable of thinking in images are only able to be impressed by images.”7

To a crowd, few images are more seductive than the promise of instant wealth. The picture of vast riches that would normally take a lifetime of hard work to accumulate, if you were lucky, being won effortlessly in just a few days or months is almost irresistible. Think of all of the house buyers in the early 2000s who took on huge mortgages they knew they really couldn’t afford. There’s no question that Mackay and Le Bon were outstanding observers far ahead of their time, but what wasn’t available to them is the recent research that explains in more detail why crowds can be swept away to such levels of irrationality.

A Glimpse at the New Psychology

The psychological studies that explain a good part of these consistent and predictable behavioral errors began in the 1970s. That work eventually earned two of the leaders in the field, Daniel Kahneman and Vernon Smith, the Nobel Prize in Economics in 2002. Even more cutting-edge research began coming out after I published Contrarian Investment Strategies: The Next Generation in 1998. The new research provides major findings in both cognitive psychology and neuroeconomics that explain why bubbles are so powerful and repeat themselves so frequently, as well as why contrarian strategies have worked so well over time and should continue to outperform other approaches in the years ahead.

Just as psychiatrists have learned much about the functioning of the human mind through the study of disturbed patients, researchers in this field have investigated manias and crashes to gain valuable insights into financial decision making. Investment bubbles are the clearest examples of investors’ overreaction because the disparity between value and price is at its most extreme.

I think this work is only the beginning in this exciting field.

This research helps greatly to explain why people become caught up in manias and bubbles and why it is so hard to recognize what’s happening. So let us bid adieu to the wry and humorous images of eighteenth-century English duchesses and red-faced twenty-first-century investment bankers, all desperately scurrying after beckoning fortunes, and move on to the emotions that bring them to this state.