February 24, 2021 | Psychological Foibles Behind Financial Errors

Many of today’s market participants have no first-hand experience of an extended bear market that grinds asset prices lower over many months and does not recover prior highs for many years.  Others have experienced an extended bear market in the past, they should know better, but they believe (hope) this cycle is different.

The Dunning-Kruger Effect is the psychological condition of knowing so little about a subject that a person doesn’t even realize how little they know, leading to an over-estimation of personal ability.  This common affliction, along with other textbook frailties known as cognitive dissonance and confirmation bias, makes humans highly susceptible to self-destructive financial decisions, especially during asset bubbles.  Awareness and risk-controls are keys to better outcomes.

For an excellent overview of these classic foibles and some real-life context, read All Stock Market Bubbles End.  Here’s a sample:

By 1929, Groucho Marx had amassed a small fortune of around $250,000 through a combination of savings and investments. However, like many new investors in the roaring 20s, Groucho was quickly realizing acting was a whole lot more work and a whole lot less financially rewarding than investing in the stock market.

“Every day (Groucho) would go in and he’d look on the big board and he’d see that his stock had climbed X number of prices, and he had made several thousand dollars without lifting a finger. And he thought, well, this is easy.” — Maury Klein, professor of history and the author of “Rainbow’s End: The Crash of 1929.

But like all stock market bubbles, the 1920s bubble suddenly came to an end. Groucho lost everything in the crash of 1929, at the age of 40. According to historians, the tremendous financial loss affected Groucho psychologically for many years.

…In some ways reminiscent of 1999 and 1929, we have many analysts in 2021 insisting stock prices aren’t too high and instead attack investors for not being even more heavily invested. They make arguments that the economy has somehow changed and valuations no longer matter.

Apparently, the vast majority of investors seem to agree that stocks have more room to run. For example, the City Panic/Euphoria Sentiment Index is now higher than the peak of the bubble in 2000.”

Danielle Park February 24th, 2021

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