![]() No other psychological test illustrates this more clearly than the Asch conformity experiments. What’s strange, however, is that people tend to have a hard time recognizing when the herd is wrong, even when it’s obviously wrong. For example, if you’re visiting a foreign country for the first time, and you’re unsure of how to behave at, say, a religious site, you might copy the locals’ behavior so you don’t offend anybody and your visit goes smoothly.īut our tendency to copy others isn’t always adaptive sometimes the herd is wrong. This network often helps us navigate social dilemmas. Social information is processed in multiple regions of the brain, which together make up the social brain network. Over millions of years, the human brain has evolved to perceive social cues and use that information to strategically regulate our behavior. Like other primates, humans are highly social creatures who model their behavior on what others are thinking, feeling, and doing. But what causes investors to keep inflating and popping stock market bubbles over and over again? Conformity and the social brain network You can see these boom-and-bust cycles play out in markets throughout history, from tulips to Bitcoin. With essentially no new buyers showing up, prices drop even further because supply far exceeds demand. Euphoric buying turns to panic selling, which causes many former optimists to sell their holdings at any price, even at a loss. Panic: Due to some kind of event, prices suddenly begin to crash.Profit-taking: To lock in profit, a handful of “smart money” investors sell some or all of their asset holdings while prices are still high.Some bulls say prices will never crash because the asset or asset class represents a “new paradigm” or because there will always be buyers waiting to gobble up any price drops, an idea called the “ greater fool theory.” Although there are some pessimists (known as bears) criticizing the market, the optimistic investors (bulls) and analysts try to justify the inflated prices by touting questionable metrics and arguments. Euphoria: Prices skyrocket to wild highs as investors throw caution to the wind.The media starts covering the boom, which attracts even more investors, who fear that they will miss out on a great opportunity. Boom: As more investors enter the market, prices rise at a quicker pace.The dawn of internet companies is a good example: A handful of investors think the internet will be a game-changing technology, so they decide to invest early. Displacement: This phase occurs when some external force, such as a new technology, captures investors’ attention.In his 1986 book Stabilizing an Unstable Economy, the American economist Hyman Minsky gave a more technical description of how asset bubbles play out: So why did people stay? One reason is that, like stock market bubbles, it’s impossible to predict exactly when the cops are going to show up - or, in other words, when collective emotions are going to shift from euphoria to panic. ![]() In retrospect, it was clear that the party was going to get busted. Some of the kids who stayed too late suffer the consequences. But inevitably, the cops arrive and bust the party. By midnight, a few wiser kids leave because it’s getting out of hand. Then word spreads among the whole class.Īfraid of missing out, carfulls of kids start showing up. A handful of other kids hear about the party and show up. ![]() The party starts with a few people, maybe hanging out at a kid’s house whose parents are out of town. To get a conceptual grasp on how bubbles form, imagine a high school party that gets out of hand. Then the market suddenly crashed in 1637. Tulip bulbs became so fashionable that prices rapidly soared, with some rare bulbs reaching prices that far exceeded the average annual income of Dutch workers. One of the earliest and most famous examples is the tulip mania that occurred in 17th century Europe during the Dutch Golden Age. Asset bubbles can occur in any market - including stocks, real estate, and commodities - and they’ve existed ever since people have been trading in markets. Like soap bubbles, asset bubbles inevitably pop, causing a sharp drop in price. The science of ‘herd mentality’ | Your Brain on Money | Big Think What is a stock market bubble?Ī stock market bubble - or more broadly, an asset bubble - occurs when the price of an asset inflates far above what it’s fundamentally worth.
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