Thursday, July 11, 2013

the last book I ever read (dot.con: How America Lost Its Mind and Money in the Internet Era, excerpt seven)

from John Cassidy's dot.con: How America Lost Its Mind and Money in the Internet Era:

Many mutual fund managers carried on buying stocks even though they believed them to be overvalued, which was not necessarily irrational. At the end of every quarter, fund managers are assessed relative to their peers in a series of published league tables. In this environment, following the herd is often the optimal strategy, especially during a bull market. If stock prices continue to rise during a given quarter, the fund manager who keeps all his money in the market will look clever at the end of it. If the market crashes, and the fund manager’s stocks do badly, most of his competitors will look equally stupid, so he will probably retain his job. Only by stepping out of line and selling, which is what Vinik did, does the fund manager risk his position. Trapped in this logic, the vast majority of fund managers tend to keep buying stocks regardless of their prices, which makes the market even more overvalued.

The idea that rational behavior on the part of individual investors can lead to an irrational outcome—a speculative bubble—dates back at least to Charles McKay’s Extraordinary Popular Delusions and the Madness of Crowds. In his account of the South Sea bubble of 1720, Mackay stressed that most of those involved knew that the promise of riches from the South Sea trade was a myth, and that many of the bubble companies were fraudulent, but they saw the chance to make some quick money and seized it. In the memorable words of an English banker who took part in the bubble: “When the rest of the world is mad, we must imitate them in some measure.”

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