We generally need to feel a sense of belonging and acceptance and this need can be fulfilled by being part of a large social group such as a club, community center or sports team. The social setting can also be smaller and more intimate such as the one among family members, close friends and spouses.
That’s how bubbles are formed and that’s why there will always be boom and bust cycles in the financial markets.
Bubbles are formed when a particular sector, industry or fad gains momentum as more and more investors are lured by the prospect of fast cash.
Investors feel a false sense of security because they see so many people around them do the same. If they see other people make a quick profit, they cannot resist and will jump in.
One of the most common types of bubble that repeats over and over again is the real estate bubble.
I remember reading a Business Weekly article in late 2006 that showed a disturbing trend: for every 5 houses purchased in the U.S., 2 were for investment purposes.
I was fairly certain at that point that the U.S real estate market was going to crash in the near future. Being a real estate investor myself, I knew speculation had to be rampant when 40% (2 out of 5) of the houses bought were being flipped. You don't get a clearer sign of a bubble than that.
Benjamin Graham once said, you are neither right not wrong because the street agrees with you. You are right because your investment decisions are based on rationale thinking.
It’s never easy to go against the flow; it feels unnatural. It even feels unsafe. But you have to ask yourself this very important question: what is your decision based on?
It makes no difference whether it’s one, ten or one thousand individuals who are taking part in an activity. It doesn’t mean they’re making the right decision.
If you look at virtually all facets of life, it’s always a very small minority that gets it right, not the majority.
How many people do you know are truly passionate about their work versus those who hate their job or have a job just to pay the bills?
How many people do you know are happily married and enjoy a loving relationship versus people who are married but live together like roommates (about 50% of all marriages end in divorce)?
How many people do you know are successful at losing weight and keeping it off versus people who get on a quick-fix diet and gain their weight back?
The list goes on and on. When it comes to investing, don’t follow the crowds blindly. Instead, learn, learn more and keep learning. Don’t ever stop learning. Learn a bit every week and pretty soon, you’d be amazed at the size of your knowledge bank.
In the end, independent thinking is the key. Independent thinking combined with knowledge, patience, and the right temperament is the winning formula.
Check out Morningstar's classroom. It's a really good starting point to learn about investing in stocks, funds, bonds, etc.
Related posts:
Most Common Investing Mistakes - Part 1 (Overconfidence)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)
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