In this post, I continue the discussion of behavioral finance with examples of some of the key behavioral biases and where they can be seen in recent market behavior. The specific focus of this post is those biases that drive investment fads and bubbles.
It is almost invariably the risk that we ignore that really hurts us. The market today is, for the most part, discounting inflation risk. Historically, inflation has been a major threat, especially to bond investors. Today, with yields at historic lows, the implied inflation expectations are exceedingly low. The process by which the market comes up with rationales as to why a risk, that has historically done major damage, no longer matters is at the heart of every bubble. We have had the housing bubble (in which investors became convinced that houses were an infinite source of capital appreciation), the Tech bubble (in which investors decided that valuations based on earnings were irrelevant) and now the government debt bubble (in which investors are implicitly assuming that inflation risk is no concern). The bubbles get out of control largely because people assume that what has worked recently will continue to work. Continue reading