When John Law developed his scheme to help France avoid bankruptcy in 1717, people scrambled to invest in his company. It was emotional. Neighbors were becoming millionaires. Everyone was making money. It was a frenzy. It was completely irrational, but a frenzy nevertheless.
In Bamboozled by the Intellectual Elite we described how investors at times take what people of stature say without question. John Law concocted his plan to help France pay off its debts by selling shares in the Mississippi Company. He was the top financier of the day. People trusted him; they believed him without testing his underlying thesis. Investors that bought into the Mississippi Company at the wrong time got smoked.
John Law’s scheme was an irrational belief system advanced by a person of stature.
An irrational belief system once formed can take on a life of its own, particularly when the irrational belief system involves securities. The actions of early adopters drive the price of the security up. The increased price provides positive reinforcement to the validity of the underlying thesis. The positive movement in price is a false positive reinforcement in the sense that the underlying thesis is irrational and faulty, but for some that positive movement in price coupled with an endorsement from a person of stature is all it takes.
People lined up outside John Law’s house to buy what turned out to be a worthless security. The price action of the security and Law’s endorsement gave people all the proof they needed. They wanted in.
Early adopters drive the price of the security up, which attracts a second wave of new investors. The second wave increases the price of the security further, providing positive reinforcement for the third wave of investors. The irrational belief system becomes self-reinforcing with the price action from one group giving positive reinforcement for the next.
When irrational belief systems become self-reinforcing, bubbles form. They grow not from a rational analysis of the situation, but from the self-reinforcing nature of the irrational belief system. They are fueled not by logic, but by emotions.
That is how the nifty fifty became a bubble in the 1960s. It is how the dotcoms became a bubble in the 1990s. It is how the housing market became a bubble in 2008. Investors banked on a false sense of security - and on a false validation of the thesis - created by a self-reinforcing system. The theory was irrational. The system was self-reinforcing.
Self-reinforcing and out of control irrational belief systems create enormous market risk for investors. They represent systemic errors in that many market participants make the same mistake in the same direction. Their actions create eddies of inefficiencies in market prices, sometimes resulting in overpriced securities.
Securities subject to these self-reinforcing irrational belief systems become overvalued and stay overvalued until the error reveals itself. When the error becomes obvious, the market corrects. People lose money.
We have found over the years that it is far easier to spot these irrational belief systems in action than it is to predict the timing of their reversals. Our inability to predict the timing of their reversals is the main reason we don’t short securities.
We believe Tesla is overvalued, for example, due to one of these self-reinforcing systems. We likewise believe an out of control self-reinforcing irrational belief system has affected the price of Bitcoin. We in fact see these types of systems at work practically everywhere we look today. Our strategy is not to short them, but to simply stay away from them.
Identifying one of these systems at work requires three things: 1) independent thought, 2) a commitment to thoroughly test all belief systems for rationality, and 3) a willingness to look out of step occasionally while others are making what looks like a lot of money.
