Market Watch: The Psychology of a Stock Market Bubble

Article by Mark Hulbert in Market Watch

I have no idea whether the stock market is actually forming a bubble that’s about to break.

But I do know that many bulls are fooling themselves when they think a bubble can’t happen when so many of us are concerned about one. In fact, one of the distinguishing characteristics of a bubble is that such concern is widespread.

It’s important for all of us to be aware of this bubble psychology, but especially if you’re a retiree or a near-retiree. That’s because, in that case, your investment horizon will be shorter than for those who are younger, and you therefore are less able to recover from the deflation of a market bubble.

This widespread concern is entirely consistent with a bubble’s formation, according to a definition proposed several decades ago by Robert Shiller, the Yale finance professor and Nobel laureate. According to him, a bubble is “a market situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, bringing in a larger and larger class of investors, who, despite doubts about fundamental value, are drawn to the investment partly through envy of others’ successes and partly through a gambler’s excitement.”

Rather than responding by taking some chips off the table, however, many began freely admitting that a bubble was forming. They no longer tried to justify higher prices on fundamentals, but began justifying it instead in terms of the market’s momentum. Prices should keep going up as Fear Of Missing Out (FOMO) seduces more and more investors to jump on the bandwagon.

Needless to say, things don’t go up forever. Those who nevertheless continue to invest in such an environment do so with the implicit assumption that they will be able to recognize it, in advance, when the bubble is about to pop—and therefore able to leave the party before everyone else. This is a dangerous delusion, however; not everyone can be the first to leave the party.

The bottom line? Far from being a reason why a bubble isn’t forming, the widespread current concern about a possible bubble is actually a reason to ......

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