There is one thing that haunts me as an investor. It is not crashes, bubbles, or recessions; it is the theory of efficient markets. It is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently over the long term since market prices should only react to new information. No matter how hard I try or how smart I am, I just can't beat the markets. How can I let luck ride my whole future and career? For me, that's frightening.
The problem is that I believed in it from the day I heard it until recently. What changed my mind? Understanding that people aren't really rational all the time. As long as the people with access to capital aren't rational or efficient 100% of the time, it is also impossible for the markets. What makes us the smartest species to ever exist irrational and dumb? when everything everywhere all at once is working against us, i.e The Lollapalooza effect .
The Lollapalooza effect basically means the incremental effects that are caused by multiple forces working in the same direction which ultimately leads to seismic events( good or bad). These effects can cause crashes and destroy wealth but also create opportunities and enormous wealth.
Let's first see how it can negatively affect us.
I think of this effect in two ways: First is when the psychological effects come into play,such as the multiple biases from the psychology of human misjudgement. Second is when economic factors such as liquidity, interest rates, increasing debt, risk tolerance, etc, come into play. Low interest rates and liquidity are essential to a bull run. The problem is not that these factors are bad; it's that a lot of people fall prey to the extended bull rally and never let rationality prevail.
Let me give you examples to simplify this.
Dot-com bubble crash.
It was a spectacular bubble that happened between 1995 to 2002. The Nasdaq rose by around 3700%( for an index to rise like that in seven years is massive), only for the bubble to burst and all come crashing down. It seems foolish; how did people fall for it when most of the tech companies were loss-making, and there was no way for the valuations to sustain? It is when all the tendencies and economic factors come into play and greed takes the front seat.
Let's understand it by the Lollapalooza effect.
Overconfidence: The upgradation of the internet and WWW increased the conviction people had for internet companies, assuming that new-age companies do not follow the same metrics that the traditional ones do.
Confirmation bias: With the increase in liquidity, low-interest rates, and confidence in internet companies, prices rose, and that led to people believing that the business was legit, which led to a further inflow of capital.
Herd behaviour: with most profiting from internet companies, why will the rest not want to do so? The people who weren't the original believers of the concept jumped the train as they saw everyone making 100% gains in a few months. It's hard to stay patient when everyone else does, but you are becoming a millionaire.
Recency bias: A frenzy of IPOs with increasing media coverage of internet companies led everyone to believe that these companies are it and it is the future of the world.
Anchoring bias: a rise in stock price is not the same as a rise in a business's quality. People failed to understand that stock performance was not attached to business performance.
The rapid growth promised didn't continue; valuations peaked, interest rates hiked, liquidity decreased, investors panicked, and the markets corrected. The same reasons led to the rally being reversed, and so did the rally. If there were corrections where rationality prevailed, it would not have been a bubble. The problem arises when the positive lollapalooza economical factors lead to the psychological lollapalooza effect, which takes everything to extremes and causes disasters.
If we were to look at the 2008 global crisis or the 1929 Great Depression, the factors would be the same. It is like there is a template to be followed, and all that changes are the people. The factors, effects, and emotions are all the same.
Lets not hate the effect too much,Positive lollapalooza effects can cause tremendous opportunities as well. When I look at opportunities, I broadly classify them as geopolitical changes, technological innovations, government regulations and mean reversion. The Lollapalooza effect comes into play with this as well.
Let's look at a few ideas.
China plus one: This theme is a creation of multiple effects into play. First, there are geopolitical tensions between the West and China. Second, supply chain disruption by Covid. Third, Incremental manufacturing capex by India and finally, the demographic dividend that India has. Factors such as manufacturing capex and demographic dividend were obvious, and a long time in the making; the onset of covid-19 was the key catalyst. These factors combined led to massive wealth creation and created a structural trend which is still intact.
Rise of EVs: The rise of EVs is a result of multiple effects. Global warming is the primary reason, followed by continuous technological advancements, policies favouring EV production, a cultural shift towards concern for the environment, etc.
Every major event can be traced back to its root causes and how they affected them. I struggle to understand them while reading about them, so I know it will be extremely difficult when I attempt to predict such trends. However, reading history is probably the best way to understand the effects of the lollapalooza effect.
This marks the end of my attempt to mix psychology with the markets. Next few months will be a combination of learning the story of great Indian businesses, sectoral analysis and much more,
Stay tuned!
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