Have you ever wondered why some companies' stock prices are exorbitantly high? If you follow the share market, you will notice some penny stocks (stocks with a very low face value, usually under INR 10) that reach abnormally high prices in quite a short time. If you have been in the markets for a longer time, you must have heard people speaking about stock market bubbles.
You might have also noticed people talking about real estate prices. What usually happens in those conversations is that someone is recommending buying a property as “prices will appreciate, it is a great investment,” while someone else at the same time will say that “do not buy property, a crash is incoming soon.”
How are these ups and downs in prices being influenced? What is the influencing factor here?
Financial markets are considered to be rational. Every valuation of an asset reflects information that is true and fair. However, that is usually reflected in the long term. In the short term, these manic highs and depressive lows, causing stock market bubbles, are influenced by a factor that’s too big to fathom. And that is – our human brains.
Human Psychology in Play:
Humans are, by nature, irrational. Human psychology is so concrete at times, and so fluid at others, it is near impossible to predict what a simple human will do when faced with choices and decision-making. Thousands of scientists, psychologists, and researchers have been trying to decipher the human mind for centuries. The result? Psychologists say that we still understand only about 10% of how our brain operates.
To truly understand the irrationality of humans, let me take you back to the 17th century. It is 1634 AD, and the Dutch Republic (now the Netherlands) is at its peak, the Dutch Golden Age. To foster culture and economics, many new plant forms were imported into the Dutch Republic from Europe like potatoes, tulip bulbs, peppers, etc. The Dutch Republic is a place with severe harsh cold winds. People soon found out that amid all the new plant lives, tulips survive the best in that cold climate. Also, the color of the tulips was vastly different from all other flowers known at that time.
As a result, tulips soon became luxury items, coveted by all. They stood out among other flowers because of their luxurious color and intricate patterns. They survived the cold winds, but it was notoriously difficult to reproduce the tulips. So, as they grew in popularity, people started paying more and more to obtain them. Soon, speculators also entered the forward market and contract prices of tulip bulbs continued to rise, throughout 1636. At one point, the price became so high, you can surmise the abnormality of it by the fact that a person offered 5 hectares (12 acres) of land for one single tulip bulb. 12 acres for a single tulip bulb!
Eventually, the demand became too high for people to deliver. In February 1637, all of a sudden, tulip bulb prices crashed. The Dutch economy suffered major losses economically. The majority of investors went bankrupt. This incident is one of the very first recorded cases of an economic bubble. This phenomenon is still referred to as the Tulip Mania.
The human brain is unfathomable. Can you ever imagine giving away land for a simple tulip bulb? What are the implications here?
It was not that the tulip bulbs were special, it was the illusion of it being special. The scarcity of anything makes it rare, and it is human nature to hoard rarity. In our current times, look at gold right now. It is of limited supply, which is why it still holds so much value. Other than that, it has no use as an asset. It does not produce anything, and neither can you use it as an exchange of value like money.
Another example is cryptocurrency. It is also a classic case of a bubble, fuelled by manic highs and lows. Faced with severe crashes this year, people are perhaps realizing that it also cannot be used as an asset, and there are difficulties in it being a monetary exchange of value. Still, people keep buying it in hopes that one day their investment will return tenfold. This is simply speculation, augmented by herd mentality.
The point is, human psychology is vast. When faced with choices, whether in real life or the stock market, you need to make informed choices. Herd mentality will only ever lead to losses like those investors of the 17th century. Informed choices require making decisions deliberately, with full awareness and insight.
So, keep thinking, and happy investing!
- Vaishali Patwa