Why do we fall for bubbles?

It can happen at any time: market bubbles burst, companies crash and burn, investment portfolios become worthless overnight. The common denominator in these events is overconfidence, irrational exuberance, call it what you want, it all comes down to lots and lots of people taking risks they shouldn't take.

Why do we do this to ourselves, in spite of all logic to the contrary?

We even have age-old sayings we choose to ignore all the time: What goes up, must come down; the bigger they are, the harder they fall; don't put all your eggs in one basket. Jerry Garcia of The Grateful Dead sang, "'Cause when life looks like easy street there is danger at your door."

Do we listen? Nope.

When we're caught up in a bubble frenzy, we have a funny way of ignoring conventional wisdom. We instead choose to believe that whatever it is we're doing somehow goes beyond logic. We feel power in numbers because everybody's doing it.

Investment banks are notorious for fueling bubbles. They funded the real estate bubble that led to the subprime disaster. They also fed the Internet bubble by writing research reports that supported ridiculous valuations and by underwriting public offerings based on little more than concept.

But banks aren't victims of bubbles; they're catalysts. You see, as bubbles grow, banks make record profits and their executives take home huge bonuses. Who cares what happens when the bubble bursts? It's not as if they have to give the money back. Only investors are left holding the bag. So what?

At least banks have an excuse for fueling bubbles. It's called greed. What's our excuse for falling for it?

And why don't investors diversify even when they know they should? I've been guilty of that myself. I know a guy who made $20 million when his company was bought by Cisco Systems. A couple of years later, he still had it all in Cisco stock. The guy's not crazy. He's not dumb. What's up with that?

Google's stock rose 75 percent in one year and then dropped the same amount in two months. Apple's share price skyrocketed from $87 to $200 and then fell back to $120, all in the space of 12 months. Tessera just dropped from $40 to $14 in two weeks.

When bubbles burst, hundreds of billions--sometimes even trillions--of investment dollars can be lost. We're not talking about small stakes here.

Bubbles aren't just about groups, though. People who should know better and can afford it run around without health, homeowners, or automobile insurance. What are they thinking?

All bubbles inevitably burst. And it isn't pretty when they do. So why do we do it? Why do we so readily believe in bubbles? More specifically, why do we take risks we know we shouldn't? Why are we so willing to forgo common sense on the ludicrous notion that all the sayings will be wrong this one time?

The answer isn't mass stupidity or insanity. It isn't greed, like with the bankers. It's certainly not just risk-taking or we wouldn't feel so disillusioned and guilty when our illogical hopes and dreams disappear overnight.

Some say it's hope or faith, but I'm not buying it.

The answer is ego. Each of us has the capacity to completely ignore all logic and reason, to delude ourselves into believing that we're so special that nothing bad will happen to us. When we take risks that our bank accounts can't cash and deep inside we know better, we're being just a little bit too full of ourselves.

I know that sounds judgmental, but I'm as guilty as anyone is. It's not a terrible thing. Judging by the shear number of people who get swept up in bubbles, the phenomenon appears to be an integral part of human nature.

So, when you fall for a bubble and it bursts, try not to be too hard on yourself. It can happen to anybody, and it most likely will. After all, we all have egos.

Just pay up and try to remember what it felt like the next time your ego starts to indulge itself a little too much. You can do that because all humans have a built-in system of checks and balances. It's called learning from our mistakes.

[RonC32-ASA]

This is so good! Sadly, so true.

Like you say, we are all guilty of it.......and I bet doomed to repeat it, hopefully to a lesser degree each time.

Keep'em coming.........someone will listen!

[The User]

Not greed? Wasn't the real-estate boom all about the greed of millions? Seemingly everyone was making easy money flipping houses, buying rental properties and investing into real-estate through financial vehicles. It's wasn't the banks (although there were as stupid and greedy), but the greed of an ordinary citizen who smells easy money and loses his brain following the smell.

[ghostofitpast]

Not to be pedantic, but, technically speaking, the answer is Id, rather than Ego. As a matter of fact, your timing could not have been better, because this is also the answer to why Eliot Spitzer got into HIS mess:

http://therehearsalstudio.blogspot.com/2008/03/evolutionary-perspective-on-vice.html

Terminology aside, you got the basic thrust of the argument. We are not ruled by "logic and reason;" and there is a good chance that we are the way we are by virtue of natural selection, which means an Id stronger than Ego has survival value!

[Radish555]

I don't think it's ego; it's called "confirmation bias" and happens with everything, not just finances.

http://en.wikipedia.org/wiki/Confirmation_bias