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Feb 12 2008

The brave new world of finance-6: Greed and bubbles

(For previous posts in this series, see here.)

One can never underestimate how the power of greed, the thought of making a lot of money quickly, can cause otherwise rational people to lose their senses. A friend of mine works for the white collar crime division of the Cleveland police and he can tell story after story of sensible middle-class or wealthy people, the kinds who could be your neighbors, who are professionals and cautious in most of their dealings, becoming the victims of some racket run by charming men and women. These people often did not even need the money they thought they would quickly make. In each case, it was greed that overcame their judgment, coupled with the desire to feel that they too are smart investors with access to valuable information that the general public did not know. Conmen and conwomen know exactly how to prey on such people.

Greed is also what fuels bubbles. The so-called ‘dot com’ craze of the late 1990s is within recent memory of most of us, where privately-held internet companies would go public and sell stocks, whose values would then skyrocket literally overnight. Initially some people made a lot of money and this soon attracted more naïve investors who assumed that the good times would always last. But they never do and in 2000 the inevitable crash came, wiping out nearly 80% of the paper value of people’s investments.

While most of us are not the kinds of financial high rollers who get invited to participate in such IPOs (Initial Public Offerings), it is easy to get sucked in by the general enthusiasm and try and get in the game later, when the savvy investors have already made most of the money to be made. It may be hard for us to comprehend how people could get so unhinged that they forget the basic rules of investment and fall prey to speculation. But I can see how other naive people like me could easily get sucked in and invest their savings thinking that there was easy money to be made.

As economist Burton Malkiel says in his chapter on bubbles in his book A Random Walk Down Wall Street (1999):

Not all investors in the bubble companies believed in the feasibility of the schemes to which they subscribed. People were “too sensible” for that. They did believe, however, in the “greater fool” theory – that prices would rise, that buyers would be found, and that they would make money. Thus, most investors considered their actions the height of rationality as, at least for a while, they could sell their shares at a premium in the “after market,” that is, the trading market in the shares after their initial issue. (p. 43)
. . .
The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard, really, to make money in the market. . .What is hard to avoid is the alluring temptation to throw your money away on short get-rich-quick speculative binges. (p. 53)

During the dot-com boom in the late 1990s, I would read almost every day of yet another internet company that would have an initial release of stock and of those who bought them finding their investment doubling or tripling within days. Even I had the vague feeling that by not participating in this boom, that I was somehow losing out, that I was falling behind by standing still. I felt a tug, a temptation to ‘get in the game’. But I did not actually invest during the dot-com boom because not only do I not understand the stock market, I do not even like the principles on which it works, where bad news for ordinary people seems to mean good news for investors.

For example, I recall the day in July 2005 when terrorists struck the London underground trains, killing many people and causing panic in the financial markets. Brit Hume of Fox News said that when he heard the news, the first thing the occurred to him was that it would be a good day to invest in the stock market, to take advantage of the sudden drop in stock prices due to the tragedy. I was stunned by that shameless display of callousness and greed. I simply cannot imagine thinking like that, to eagerly look forward to tragedy and disaster as opportunities for making money. It seems ghoulish to take advantage, however indirectly, of the misfortunes of others. And so I cannot bring myself to directly ‘play the market’, as they say, although my retirement accounts are presumably being invested by someone who is playing such games, so my hands are by no means clean.

But it is not only big investors who can fall prey to that kind of hype. If you find it hard to imagine that normally level-headed people could go nuts over things like tulip bulbs, recall the idiotic Beanie Baby craze of the 1990s. The prices of those cheaply made and nondescript toys started rising insanely as certain of those stuffed animals, sometimes for no discernible reason other than a rumor that they would become scarce, suddenly became highly sought after items. Ordinary people started lining up at stores on rumors of their availability and started paying far more than what they could afford for things that they thought would become collectors’ items. The idea of an everyday item (a small, mass produced, cheaply made stuffed toy!) becoming a valuable investment vehicle was bizarre. This was such an obvious mass hallucination that I could not believe it was happening before my very eyes. Clearly reality had to prevail at some point and that bubble also crashed, leaving some people with huge quantities of Beanie Babies that they could not sell at even the list prices.

But while the Beanie Baby example was illustrative in the way it caused some people to spend more money than they could afford, it has had nowhere near the devastating impact that the current sub-prime mortgage bubble debacle has spawned. Once again, as with the tulip bulbs or Beanie Babies or the earlier dot-com bubble, the problem begins when the price of an item gets divorced from reality.

Next: The subprime mortgage bubble.

POST SCRIPT: Ricky Gervais in Extras

Comedian Ricky Gervais, who created the original The Office, has a new comedy series called Extras, where he works as an extra and tries desperately to ingratiate himself with the stars in order to get a break or at least a speaking role. This gives the show the chance to have famous actors as guests for each episode.

In this scene, we see him with Patrick Stewart.

2 comments

  1. 1
    Geld Lenen

    Greed is everywhere in the world. On 9/11 there were some people that instantly became millionaires, because of the stock options the had bought.

    On the other hand, why wouldn’t you buy those options? I mean, you can’t do anything about the horror at that moment, but you can make money.

    It’s a real dilemma for some, but I think I’m not capable of making money in these situations.

  2. 2
    Hans

    it’s not an easy task to overcome our greed. it’s up to us on how to control it.

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