Behavioral finance has emerged as a discipline over the course of the last 20 years. This new field is the result of a syncretism of economics, psychology, psychoanalysis, and neuroscience. It is a new field in which many turf issues are undecided and from which a definitive market paradigm has yet to emerge.
The dominant market paradigm operant in finance is that of the efficient market hypothesis (EMH). The efficient market hypothesis states that the price of any security at any moment accurately, or efficiently, reflects everything that is known about that security. In fact, EMH implies that the price not only reflects a full range of knowledge about that security but also everything known at that instant about the entire stock market; also the economy in general, society at large, and so forth.
The only trouble with the EMH, which incidentally is taught as the gospel in more than 90 percent of the leading U.S. universities, is that it is patently wrong. Every practitioner in the field knows this. Any money manager knows that the mastery of emotions connected to money and to investing is paramount to good investing. This was often simplified to mean conquering greed in bull markets and surmounting fear in bear markets.
The other psychological fact long recognized in investing is an awareness of group dynamics or the herd instinct. Surprisingly, the herd instinct seems to impact professional investors even more than individual investors, although, in truth, both groups are strongly affected.
The first serious treatise on market psychology was the oft-quoted, seldom read Extraordinary Popular Delusions and the Madness of Crowds written by David MacKay, published in 1832. MacKay examined three historical speculative market bubbles: Holland's 17th century tulip mania; the 18th century South Sea Company bubble in England; and the Mississippi Land Scandal in 18th century France.
The first serious treatise on market psychology was the oft-quoted, seldom read Extraordinary Popular Delusions and the Madness of Crowds…
Tulips were first introduced into Holland from Turkey in the 15th century. Growing conditions in Holland turned out to be excellent for the propagation of new lines. What started as a passion of royalty and the rich quickly spread to Holland's newly emerging middle class. In 1635, a new strain dubbed “the Viceroy” gained enormous popularity. Initially quite rare, the possession of a few Viceroy bulbs conferred celebrity status on the owner. Within six months the price for a Viceroy rose from 35 florins to more than 2500 florins. It is difficult to translate those prices into 21st century currency. In 1635, 2500 florins would have purchased a suit of new clothes, a new bed, four oxen, eight swine, thirteen sheep, 1,000 pounds of cheese, and four lasts of rye. In other words, more than a year's salary for a skilled artisan. The problem, of course, which should have been foreseen by anyone, was that it did not take Holland's skilled horticulture industry very long to propagate the Viceroy in such great numbers that the Viceroy's price tumbled even more quickly than it rose, reaching a low of less than 50 florins within six months.
A similar story surrounds the South Sea Company in England. The company was founded in 1711 by the Earl of Oxford and did indeed have a valuable possession.
Parliament had granted the company a monopoly on trade with England's South Sea possessions. Armed with this incredible franchise, the company was a booming success. Earnings poured in and dividends soared as did share prices. In 1720, the year of the Great Bubble, the stock rose from 128 shillings to 890 shillings in less than six months. The success was so dazzling that Parliament gave pensioners the option of trading their annuities for South Sea stock. Later in the year, the price rose above 1000 shillings. At that point, the board of directors decided on an expansion plan and flooded the market with five million new shares. The market collapsed, with shares dropping overnight to 135 shillings.
John W. Schott, M.D., is a member of the Boston Psychoanalytic Society and APsaA's Investment Committee. He is director and portfolio manager at Steinberg Global Asset Management. He also publishes a monthly newsletter on investment psychology, The Schott Letter.
Thousands of people were ruined and the Bank of England, itself a large purchaser of shares, was on the brink of bankruptcy. Crisis was averted by a transfusion of Rothschild cash delivered from France.
The last of MacKay's bubbles was the Mississippi Land Scandal. In 1716, France was nearly bankrupt due to Louis XIV's extravagant life style. John Law, an Englishman living in France who also was a very close friend of the Regent of France, convinced Louis that economic salvation was at hand by developing the land in the New World. Law and a large number of his royal friends formed a company which partnered with the crown to develop a large tract of Mississippi land. In a manner not dissimilar to modern promotional techniques, Law initiated a tremendous promotion of his new company. He published an inflated prospectus backed by many prominent first investors who were granted special deals. In Ponzi scheme fashion, dividends were paid from the outset by using new investor money to pay initial investors. In truth, Law may actually have believed in the viability of his venture. There was intense trading of the company's stock on the Paris Bourse. One colorful tale associated with the company's trading is about a real-life hunchback who emerged from Notre Dame every afternoon to trade thousands of shares. Many other investors imitated his every move. The end of the fairy tale ride came when the first colonists arrived in Mississippi, where they found that the mosquito infested, indigenous malaria and yellow fever land they had purchased was six feet under water. When the news hit Paris, the stock collapsed.
As to Louis XIV and his dire financial straits, the outcome was similar to the South Sea Company story. It was the Rothschilds to the rescue once again.
From MacKay's work, present day master investor and market psychologist Martin Pring has inferred the following set of rules to judge whether or not a market run-up constitutes a speculative bubble. (As you read along, you might compare the Internet bubble of 1998-99 to see if you spot the signs.) First, there must be a novel idea which is initially impossible to disprove. The first companies out of the gate will be serious endeavors with capable managers. The private investors involved will be affluent and sophisticated. New experts will appear to justify prices beyond acceptable value measures. Media and ordinary investors will clamor to get on board. Imitation companies will be spawned by Wall Street manipulators. As the bubble expands and expands, it will be a simple revelation which bursts the bubble. The collapse will be so sudden that few investors—large or small, institutional or individual—will be able to get out whole.
This is the first in a series of articles reviewing the emerging field of behavioral finance.