The markets, however, are only half the game. The rest is how we reacted to market events and why we bought into the idea that home prices would never fall. A common question one hears from investors is why financial advisers and analysts didn’t realize what was happening and predict the downturn. A less common question one hears a few people asking themselves is why they didn’t realize what was going on and anticipate the collapse. Very few people think back to how they felt in 2006 as the housing boom was peaking, or what they were feeling in 2002 as it was getting under way.

Why Didn’t Anyone Notice?

Let’s begin with 2002. The bear market that started in March 2000 was bottoming out in the last quarter of 2002, the economy was creeping out of a shallow recession and many were still nervous about global politics after the events of Sept. 11, 2001. Investors were worried, and no one expected the housing boom. Indeed, not many even expected the market to recover from a 50 percent loss in only five years. Between fear and greed, fear ruled the day. Yet both the stock and housing markets were at a bottom, and were about to surge upward.

Now, consider the summer of 2006, when housing was peaking. Investors’ attitudes were completely different. The economy was growing, stocks were gaining and the S&P 500 had risen from under 800 to over 1200 since the fall of 2002. The big news was in housing, where home prices were up sharply, with some sunbelt cities seeing prices over twice the levels of early 2000. The last thing on most investors’ minds was a collapse. Between fear and greed, greed ruled the day.

Figure 3 shows the Kindleberger boom-bust cycle seen in Figure 1 and adds a second line illustrating the level of risk that investors perceived. In 2002, when fear ruled the day, people saw very large risks; in 2006, when greed dominated, perceived risks were small. The track of apparent risk is just the opposite of the market—at market bottoms we see huge risks, while at market tops we are incredibly bullish.

A large part of risk management is knowing if a particular risk is justified by the opportunity of reward. In the markets, as in most things, the size and probability of the reward varies with time and conditions. Yet the way most of us think about the markets gets the timing and probability of success backwards. There is more to investing than reason and numbers when everyone else is paralyzed with fear. The trick is to recognize when the madness of the crowd is prodding you to believe in the popular delusions.

Endnotes

1) Walt Kelly, cartoonist, in 1971 commenting on Earth Day and pollution

2) Charles MacKay, “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds,” 1841

3) 1978; 5th edition 2005, John Wiley & Sons, Inc.

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