Extraordinary Popular Delusions 2012

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Extraordinary Popular Delusions 2012

In 1841, Charles Mackay’s book Extraordinary Popular Delusions and the Madness of Crowds1chronicled how, time after time, investors have been caught in a frenzy of speculation.  In the early 17th century, investors sold their houses to buy tulip bulbs that they then hoped to sell to other investors at higher prices.  In the early 18th century, investors inflated both the South Sea Company bubble and the Mississippi Company bubble.

In each case, people allowed themselves to be swept along by the idea that they could get rich by investing in something that would keep increasing in value, even though this idea defied logic.  Because so many people were chasing the same delusion, increasing numbers of people were infected by the “madness of the crowd.” 

As Mackay explained, “Men...go mad in herds, while they only recover their senses slowly, and one by one.”  That return to sanity only happens when each investor comes to the painful realization that there is no “greater fool” to be found and the shares he feverishly purchased are worthless. 

If Mackay were alive today to write a sequel, he undoubtedly would add chapters on the dot-com bubble at the turn of the century, the housing bubble of the last decade, and the Facebook IPO debacle of 2012.

Each of those investment manias followed the classic pattern Mackay identified, in which people’s judgment becomes so clouded that the thought of the investment not going up never enters their mind.  The only negative they can imagine is the price skyrocketing without them on board and everyone else making a killing.  So, they jump on board. 

All delusions are fed and nurtured by anecdotal evidence that is rooted in “truth.”  The delusion many have of winning the lottery or of getting rich at the blackjack table in Las Vegas is supported by the fact that some people are indeed allowed to win.  The delusion is that people think they will be among the tiny few who will profit, even though the casino and the lottery thrive on the losses of millions of people.

Likewise, in the financial world, there are data that fuel the IPO delusion just as surely as oxygen gives life to a fire.  This data comes in two forms:  high valuations of start-ups that have not yet gone public, and stock prices of IPOs that have actually risen and remain higher than their initial offerings.  The first should be considered pure froth, and the second, like winners in Las Vegas, are certainly the exception, not the rule. 

According to The Wall Street Journal,2 there are now at least 20 Silicon Valley closely held start-ups backed by venture capital that are worth $1 billion or more, according to their valuations...

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