Prospect theory, a flourishing school in psychology these days, argues that people treat losses and gains differently--they set a baseline reference point and get very annoyed at dropping down below it, while getting only moderately happy going an equal distance above it. (Id or others who know this stuff better, please correct me if I'm way off.) I think that explains people's reactions, especially if we assume that during the bubble people's "frame," or reference point, shifted upward significantly.
Let's say that in mid 1999 Joe Blow's account had $X, and he hoped for an annual return of 30% (hey, he was a cocky bull-market tech investor with a pocketful of G's and K's!). By early 2000, Joe's account might have risen to $2X, possibly even more if he had been very lucky or had used leverage. Boy, was Joe happy then! He recognized that this was partly a bubble, but felt strongly that a lot of it was justified. So mentally he ratchets up his baseline wealth reference point to $1.5X, with a hoped-for annual growth rate of 40%.
By late spring 2000, at the bottom of the first downtrend, his account might have been, oh, $1.25X, and he was pissed--not just because it had dropped a bit (he expected that) but because it had dropped so much, even below his new reference point. But by early fall he might have come back to $1.5X and felt calm again. Not as happy as at the top, to be sure, but ok, back at the new baseline.
Then comes the fall, then the late fall and early winter, and his account plummets back to $X or even lower. The horror, the horror! Joe can't believe what's happening, and goes through kubler-ross's famous stages: denial, anger, bargaining, depression, and acceptance. But wait! The bubble is unravelling so quickly that there isn't time to go through all the stages! He never gets to acceptance, and by the turn of the year he's still stuck in depression!
When even the resolution of the election doesn't produce a rally, and the New Year begins with yet another slide downwards, he's almost there. But wait again! What's that! It's a surprise half-percent rate cut out of the blue! Uncle Alan to the rescue, and the world isn't going to end after all! The rate cut produces a giant rally and an inevitable drop afterwards, but the drop doesn't penetrate the pre-rally level much, if at all! Rather than falling apart again, the center seems to hold, and some things even rise again rather nicely.
Well, here comes Joe's friend Mike, who notices that Joe's portfolio is back up to $1.1X or even higher. Surely Joe should be happy, says Mike, because look at the gains he's made in the last few weeks. Joe is not only off his lows, moreover, but above where he was back in mid 1999.
What Mike doesn't understand, however, is that Joe's reference point was sticky downwards--it never really absorbed the fall crash, and is still at $1.5X. So in his own mind, Joe doesn't feel well off at all--he feels deeply aggrieved and impoverished, because he's well below what he feels is his appropriate level.
For most people, I imagine, frames of reference are a bit like stock prices--they track the underlying fundamental reality in the long term, but not necessarily in the short term. Joe won't be content, in other words, until either his account rises back to what he thinks is a "reasonable" level or he gets so beaten down by a stagnant market that he readjusts his baseline significantly downwards.
tekboy/Ares@allsimilaritiestorealpeopleareentirelyintentional.com |
