Soda_bubbles_macro

How Herd Mentality is creating Economic Bubbles

Have you ever wondered why economic bubbles keep happening at recurring basis. In the recent past, the world had witnessed American housing bubble in 2007, Dot-Com bubble in 2000, Asian Financial crisis in 1997 and the list goes on. If you believe that bubbles are recent phenomenon because of globalization, liberalization and free capital flow then think again. The history had witnessed Tulip Mania way back in 1637 and South Sea Company bubble in 1720 when the famous scientist Sir Issac Newton lost his entire life savings which made him remark, ” I can calculate the movement of stars, but not the madness of men”.

Why do people commit the same mistakes

Wise men always said, “Dont repeat the same mistake twice”. These are only words which people like to quote and share on facebook but hardly follow. Certain common things are hard to avoid irrespective of the efforts we put in. Two among them are greed and herd mentality. Researchers found that we try to emulate the actions of people we like or know and coined a term for this “Social Proof”. This is a powerful tool that is regularly exploited by companies and fraudsters alike.

 

Robert B. Cialdini, in his seminal book “The Influence” remarked, “We seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof”.

 

Underlying all the patience we believe we had, most of us wait for an opportunity to make a quick buck. We see our friends and relatives make a killing in the market during bubbles when asset prices soar high and hardly any logic explains the euphoria. We get tempted to try out for ourselves and burn the fingers. The affect of social proof is so subtle that it is hard to believe that we are victims to it. 

 

The greed of the market indirectly influences us troubling our rational thinking and ultimately motivates us to take steps which we would not have taken in a normal course. The asset prices appreciate over a period and on a continuous basis that people keep buying it till it reaches saturation. When bubbles burst there would be hardly any takers for the asset and someone has to sell it at a highly discounted prices leading to heavy losses.

How to avoid the traps

So next time you hear excellent news about the next big thing from someone you know, always question yourself
  • Is the next big thing real?
  • Does any logic/rationale explains the conclusion drawn by the crowd
  • Are you able to think straight without being affected by enormous pull of social proof
If you answer “No” to any of the above question then don’t do it.