Stock Market Bubbles and Crashes – A Study of Market Psychology

Knowledge of how stock market bubbles and crashes form is vital to successful investing. This article will focus on the psychological forces that lead to unwarranted exuberance and herd mentality, pushing prices beyond their sustainable levels and then leading them down into a downward spiral before eventually collapsing.

Fearing missing out on potential profits, investors often invest heedlessly out of fear. Eventually, this can lead to a stage where prices appear set for perpetual rises – leading investors into believing they’ve found an “endless bull run.”

1. Greed

Greed is an emotion with immense potential to drive market bubbles and crashes. Investors who seek quick profits at any cost, overlook risks, or otherwise ignore them may lead to exuberant prices that don’t reflect underlying fundamentals – for instance those caught up in the dot.com bubble of the late 90s dove headfirst into tech stocks without due regard for profitability or sustainability – leading to disastrous consequences in their wake.

Studies have demonstrated that those who are greedy tend to view outcomes as less fair (Kickul and Lester 2001), leading them to see market crashes as unjustified. One effective strategy for combatting greed is developing an effective investment plan and remaining disciplined during volatile markets.

2. Fear

Fear is the opposite of greed, motivating individuals to avoid risky actions and behavior. Unfortunately, fearful investors often follow in step with one another, leading to trends or bubbles as people try to mimic those around them. Additionally, it may prompt sellers to sell, potentially leading to an accidental price crash as prices drop further.

Avoid fear and greed by developing a long-term investment strategy and managing emotions effectively. Investors should understand their risk tolerance before selecting appropriate asset allocations accordingly. In addition, being contrarian by buying when the market shows signs of greed while selling when stocks plummet will help avoid being herded like cattle by investors who panicked during market dips can also help investors beat the herd. Furthermore, diversifying assets helps minimize emotional reactions; this can be achieved using long-term strategies with regular reevaluations to keep emotions at bay.

3. Expectations

Stock market bubbles form when investors’ expectations exceed fundamentals, leading to excessive optimism or “irrational exuberance.” This leads to herd mentality among investors who follow along without conducting their usual analysis of earnings and key metrics such as GDP. This results in bubbles.

Bubbles occur when investors believe a compelling narrative that supports the value of their stock, even when it misses expectations or reports negative news. When this occurs, share prices can rise even when an organization misses estimates or experiences negative developments. This happens because investors see value in believing these stories that justify why investors believe them and are willing to buy shares at higher prices than usual.

This same phenomenon also creates hot markets in initial public offerings (IPOs) which misallocate investment capital to enterprises that generate short-term speculative trends rather than long-term economic value. When these bubbles burst, their devastating consequences can leave investors without much wealth – not to mention potentially harming both the economy and financial system as a whole.

4. Euphoria

Irrational exuberance, or the psychological response to rising prices, fuels bubbles. Investors follow the herd mentality by following rising prices blindly without undertaking fundamental or technical analysis; convinced prices will continue to climb without considering that prices could reverse and collapse altogether.

Example: Amazon shares quintupled from 1995 to 2000 as part of the dot-com bubble that burst at the end of this century. Prices rose as investors speculated on new Internet-based technology companies and when prices eventually reversed many investors experienced serious losses. Furthermore, as illustrated by Figure 1, fear and euphoria index levels increase significantly during bubble periods and peak shortly before crashes; suggesting they are closely interlinked phenomena.

5. Displacement

An asset bubble forms when investors begin paying more for an asset than it’s actually worth based on its fundamentals. Prices then tend to increase rapidly during its boom stage, drawing new participants and sparking media coverage of this incredible opportunity for wealth creation. Herd mentality quickly follows suit and investors buy into this lucrative scheme en masse.

At this stage, even an unseasoned investor may find themselves drawn in. The greater fool theory applies – someone is always willing to speculate at higher costs than you are willing.

Problematic is when the herd realizes that prices cannot rise forever and begins selling, prompting a crash. While such crashes can be devastating, quantitative models coupled with expert opinions and economic indicators may enable investors to anticipate bubbles and crashes more easily.