Financial markets are in constant flux. Whether in stocks, real estate, or cryptocurrencies, recurring mania phases can bring huge profits to some, but also catastrophic losses to many. In this article, we’ll analyze the mechanisms behind these manias by examining historical examples and explore why we keep repeating the same mistakes, as well as how we might prevent them.
How Does a Financial Mania Begin?
The biggest reason financial manias occur is the expectation that *“there’s money to be made.”* Human nature is extremely sensitive when it comes to emotions related to money. When people believe they can make large profits in a market, they naturally want to jump on the bandwagon.
1. Optimistic Market Outlook
Historically, every major mania began when the market presented an extremely positive outlook. For example, during the 1600s Dutch tulip mania, people believed tulip prices would rise indefinitely. A similar pattern was observed recently in the cryptocurrency market.
2. The Psychology of Herd Behavior
When people feel smart and competent, they tend to believe their information is superior to others’. As more people invest, prices rise. This price increase signals more people to invest, and the mania grows larger and larger.
How Does a Collapse Begin?
Everyone knows prices cannot rise forever. But during a mania, it’s hard to realize this. Suddenly, when the market begins showing signs of decline, it drops sharply. Most investors then suffer significant losses.
1. External Factors
External factors such as interest rate hikes, social crises, or global pandemics can abruptly end a mania. For example, the 2008 global financial crisis started with the collapse of the housing market and subsequently shook the global economy.
2. Mass Panic in the Market
When the market declines, investors rush to sell assets simultaneously. This causes prices to drop even more sharply, leading to greater losses. Panic selling is especially common in cryptocurrency and stock markets.
Why Do We Keep Repeating the Same Mistakes?
Financial manias in markets always follow similar patterns. But why do we keep making the same mistakes?
1. The Limits of Memory
We quickly forget past mistakes. Even a major collapse like the dot-com bubble fades from memory, and investors become enthralled by new market opportunities. This happens because painful past experiences are often outweighed by the lure of present opportunities.
2. Underestimating the Mania
People tend to believe that a mania won’t happen in the market they are currently involved in. They convince themselves that the current market rise is different from past manias, and they will be the exception.
How to Survive Financial Manias
While it’s difficult to avoid a mania, there are several strategies we can employ to make wiser decisions.
1. Manage Your Risk
If something seems too good to be true, it probably is. Instead of getting swept up by a market’s rise, carefully manage your risks and maintain rational judgment.
2. Learn From the Past
Historically, manias have always repeated. By studying past manias and collapses, you can avoid making the same mistakes in new markets.
3. Don’t Follow the Crowd
In a mania, people often lose their cool in the face of herd mentality. But true investment wisdom comes from thinking independently and sometimes acting against the crowd.
Conclusion: Avoid the Mania and Make Wise Decisions
Financial markets are always fluctuating, and manias will continue to occur. But if we understand these patterns, stay rational, and make independent decisions, we can make successful choices even in the face of the next mania.
Reference: Safal Niveshak, “The Cycle of Financial Manias”