Fear, Greed and the Madness of Markets: The Decisions Investors Make

I can calculate the motions of heavenly bodies, but not the madness of people, Sir Isaac Newton wrote in 1721. His words were as much a lament as an acknowledgment of his own limitations: Newton was one of many investors who had lost their shirts in the Sea Bubble. American Heritage dictionary defines financial bubble as a speculative scheme that comes to nothing. term hadn't even been coined in 1711 when the British government granted the South Sea Co. a monopoly on trade with South America the Pacific islands. It was a time of unfettered optimism, all Sir Isaac others knew was that there were easy fortunes to be made by investing in the new venture. (Sound familiar?) Men were no longer satisfied with the slow but sure profits of cautious industry, Charles Mackay wrote in his 1841 book, Extraordinary Popular Delusions the Madness of Crowds. The hope of boundless wealth for the morrow made them heedless extravagant for today. In Newton's case, share prices soared investors grew rich overnight--on paper. Several company directors dumped their holdings, triggering a panic sell-off sending stock values to zero. bubble taught a lesson that, nearly three centuries later, many otherwise sensible individuals have yet to absorb: Financial markets are neither rational nor efficient, any investment strategy that ignores that fact is doomed to failure. Share prices move up down according to a bewildering array of factors, only some of which are readily quantifiable or even conventionally discernible by CPAs the clients they represent. A company's market share, revenue balance sheet all are key elements. But at least equally important are the vagaries of human psychology behavior, the conscious unconscious wishes, conflicts, fears fantasies that lure people en masse into bad--sometimes catastrophic--decisions. This article seeks to help CPAs better understand the often confusing market conditions that exist today by looking at the impact human behavior can have on investors the decisions they make. FLOCKING TO A DOOMED HYBRID A recent especially egregious demonstration of the madness of the markets was AOL's 2001 ill-conceived acquisition of Time Warner, widely touted as the ultimate convergence of new old media. Investors who should have known better flocked to the new hybrid. At the time, the two companies had a combined market value of $290 billion. Since then, AOL Time Warner's market capitalization has withered to $4 million; the company's $54 billion writeoff in April 2002 was the biggest quarterly loss ever. Whatever motive investors may have had for throwing in their lot with such an unworkable enterprise, it certainly wasn't rational. Psychology has a story to tell about investing, notes 2002 Nobel laureate Daniel Kahneman, and it is different from the one economics tells. In a perfect world, investors would consider all available information before making a buy or sell decision. They should not let emotions or repressed desires--theirs or the market's--enter into their thinking. In such a world, bubbles would never happen. problem, of course, is that investing never is a purely left-brain activity. Individual group psychology always has been a critical, if widely overlooked, driver of financial activity. We see things not as they are, but as we want them to be--or as we fear they will become. Or, just as irrationally, we assume things will always remain just as they are that whatever the market is doing it will continue to do in perpetuity. Is this what happens in an efficient marketplace? No such thing exists, says economist Peter Bernstein in Against the God: Remarkable Story of Risk (John Wiley & Sons, 1996). Even a cursory view of financial activity reveals repeated patterns of irrationality, inconsistency incompetence in the ways human beings arrive at decisions choices when faced with uncertainty. …