Identify the key historical lessons that can be learned from market manias and crashes

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MARKET MANIA

Behavioural economics has been gaining favour as a method for understanding how markets actually work. The now widely accepted concept of market mania, for instance, derives from the field of Behavioural Economics.

Market mania is driven by what is sometimes called the "herd mentality," according to which the masses are driven, or drive themselves, in a single direction. Safety in numbers, the need to conform, fear of standing out, fear of following one's own instincts or wisdom.

A market fad is a well-documented, less-critical, and probably more familiar example of this herd mentality. Consider for instance, the popularity in 2011 of Justin Bieber's haircut, the iPod, energy drinks, and reality television. Financial markets are similarly affected by fads: hit stocks, fetish currency, exciting new bonds that everybody had to have. When the herd mentality of fads is combined with basic emotions like envy, fear, and greed, a fad can turn into a mania, or an epidemic. Herd greed tends to drive prices and markets up, creating bubbles. Herd fear tends to drive prices and markets down, creating busts.

In 1636, tulip mania took hold in what is now the Netherlands. Contract prices for bulbs of some recently introduced tulip breeds reached prices of up to ten times the average annual wage, only to crash abruptly in February 1637.

BOOM AND BUST

The impact of a financial market boom and bust can often go well beyond the market itself and set off broader economic boom and bust cycles. We saw this in 2008 when a financial market crisis led to a more general economic crisis. Again in 2020, the COVID-19 pandemic closures led to another market crash.

How can we identify a serious cycle? The climate just prior to a market collapse tends to exhibit a number of standard characteristics. These include

• A general feeling of well-being; optimism that prices will continue to rise
• People exhibiting a high level of debt, most of it incurred to finance their investments and investment assets, such as stocks or housing
• Too many people investing in the same type of asset; the herd moving into the same space

Two stages often exist in a crash: people make money speculating on one asset and then invest in a second type. One bubble follows another.