Are you ready for the next big bull market? - Views on News from Equitymaster

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Are you ready for the next big bull market?

Apr 19, 2010

So, are you ready for the next big bull market yet? There's one coming up some time in the future. Its timing is not certain. But the fact that it will come, is. Infact, you can expect it to be a very euphoric and frothy one. Just like the one whose peak we witnessed in January 2008. One where stock prices will once again reach extremes. And best (or worst) of all, no one will complain, or find it unusual. Most investors big and small will fall for the 'stock-prices-are-going-to-touch-the-sky' theory all over again. Including, maybe, you.

How can that happen, you ask? After all, haven't we learnt our lesson well enough? After what happened right after January 2008, we surely cannot be stupid enough to bid up stock prices to such insane heights once again. We surely cannot fall for the same trick twice. Or can we?

If history is any pointer, we most certainly will. Investors have, since the beginning of free markets, gone through a cycle of booms and busts in the stockmarket. And each time a boom or a bust happens, most swear that they will not make the same mistake of paying ridiculous prices again. And then they do, all over again.

But why does this happen? Aren't humans supposed to be one of the smarter species on this planet?

Yes we are. But at the same time, our minds are far from perfect. The human mind has a number of weaknesses. Weaknesses that cause it to fall prey to many psychological pitfalls.

One among these is what is called as 'availability bias'. Availability bias is nothing but the human mind's tendency to give more importance to what's most easily available to it. And most often, what is most easily available to the mind is something that is recent and vivid. Recent and vivid events play most strongly in our mind. We over-weigh such events to a great extent in our decision making.

Not very surprising then that as time goes by, events that have occurred a while back become less recent, and consequently less vivid. In turn, they are replaced in our minds with events that have happened much more recently. These new events in turn become the ones that are more 'available' to our minds. They are the ones that we now give more weight to on a subconscious level. Indeed, the human brain tends to drift into working with what is easily available to it.

This tendency is reflected in many spheres of life. For example, if you have just seen a deadly plane crash shown on TV, you may fear traveling by plane for some time. You may feel even more fearful of air travel if you've just seen a detailed and graphical account of the same. You may feel no such fear, however, while going for a ride in your car. This is despite the fact that you stand a much greater chance of death in a car crash when compared to in a plane crash. The number of people that die in car crashes every year is far greater than those that die in plane crashes.

Our behaviour in the stock market too is no different. Investors that have just lost money in a stock market crash have that event at the top of their minds. An extremely vivid and recent event for them. It is this that keeps stock prices from touching euphoric levels anytime soon again. But as time goes by and memories of the crash are replaced, the markets slowly progress to increasingly higher levels. If this continues for a while, it is this new phenomenon of rising stock prices that is now given more importance. This ends up giving a psychological boost to investors. They then start giving lesser and lesser importance to the more distant and less vivid phenomenon of a stock market crash. Once this effect starts kicking in, investors start paying lesser and lesser attention to the prices they are willing to pay for stocks. It is no coincidence that the peak of a boom in the stock market is usually reached when the fear of a stock market crash is almost completely gone.

And in this manner, gradually the seeds of a new bubble are sowed. As we have just explained, the 'availability bias' almost ensures that this should happen. It is because of this psychological flaw that one can be sure that it just a matter of time before another bubble is formed. Only to start with the cycle all over again.

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1 Responses to "Are you ready for the next big bull market?"

Ramana Kumar

Apr 29, 2010

Valid and very pertinent write-up. The 'psychology' of investing is probably more important than any other factor in investment success. Investors need to be aware of the pitfalls they are likely to fall into and guard against them. Study of these aspects of investing has become a separate field by itself, under the banner of 'Behavioural Finance'. Equitymaster has brought out series of articles on Warren Buffet, investing principles, etc. Series on Philip Fisher is underway. It may be a good idea to generate a series entirely on behavioural finance, which should act as a ready reference point for investors.

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