Fin 393 - Effect of Groupthink on Investing

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If these symptoms and the idea of groupthink can be applied to these situations in history, there are definitely times throughout history in which the idea of groupthink can be applied to show how it negatively affected investing and the economy. So how could this all possibly be tied in to the world of investing? How can groupthink have any sort of effect on what happens in the world economies? There are many different examples of this throughout history, and they all seem to come from a very general idea. The idea of herded investors, sometimes more commonly known just as ‘herding’. This is the idea that behavior by investors can often cause big unsubstantiated rallies or selloffs on little fundamental evidence that can justify the actions. It happens because of a lack of individual decisions or thoughtfulness and people are just choosing to follow the opinions of those around them. Knowing this, I’m not sure if herding can be any more aligned with the idea of groupthink.

The simplest idea of this is when there are negative views on the economy and there are mass sell offs of stocks. One major event in US economic history that can be attributed to the idea of herding, and therefore groupthink as well, is the dot com boom and the subsequent bubble and burst of the bubble. The dot com boom began in the late 1990s and was branded by the extreme rise in equity markets all around the world because of the flood of investments coming from internet-based companies. This is shown by the extreme expansion in the technologically dominated NASDAQ index between 1995 and 2000. The NASDAQ index rose from under 1,000 to over 5,000 in that short five-year period. With many internet startups turning into multi-million dollar companies seemingly overnight, throwing large amounts of money at some of these new technology based start-up companies became the hottest trend in investing. Much of this investment was speculative, because of market overconfidence, or even just fed by cheap, easy capital. Investors were pouring millions into internet start-up companies that were nowhere near profitable with the hope that they would one day become profitable. These investors were horrified that they could be the one that failed to cash in on the growing business that was the internet and because of this they threw caution to the wind. The problem with these investments? Many of these valuations at which venture capitalists were investing were based on future earnings and profits that most definitely could not be attained for several years if everything went perfectly according to plan. The NASDAQ peaked at just over 5000 points in March of 2000, which was nearly double what it was at year to date. At the market’s peak, many of the leading tech companies, such as Dell and Cisco, placed huge sell orders on their stocks. This is significant because companies will often do this when the feel their stock price is overvalued and they went to sell some of their own shares before the price dips. This sparked panic selling among investors. The NASDAQ lost over 10% of its value within a few weeks. By the end of the following year many of the public dotcom companies would go out of business and trillions of dollars in investment capital vanished.

The dot com bubble and its succeeding burst is extremely interesting in terms of herding and subsequently groupthink. This specific economic event had an extreme amount of groupthink on both ends of the event. At the beginning, investors were throwing millions of dollars around without doing their due diligence because they were afraid of getting left behind. That fear led to mindless investing and people not thinking for themselves. If they would have done so, it is likely many people would not have invested in many of these companies that did not have the earnings to back up their insane valuations. At the end, when the bubble burst, this time it was the companies who began to realize their own fate before even their investors did. They started selling their own shares which led to massive sell-offs from investors. Looking at it this way, it is interesting to see how groupthink from both the sides of investor and company can have an effect on how the market responds and subsequently how the market performs afterwards.

Another economic event in recent memory that can be attributed to the idea of groupthink is the housing bubble in the United States. The housing bubble in the U.S can be attributed to a variety of different things but for the purpose of this paper I’m going to focus on one thing, subprime mortgages. Essentially what was happening was lenders were giving mortgages to people who didn’t deserve them. People with credit ratings that should never be given a mortgage for the amount that was being given to them. They were giving such large mortgages to people who they knew in the long run would have no ability to afford. What lenders would do with these subprime mortgages is package them into what is known as mortgage backed securities and sell them to the highest bidder on wall street. They figured that the us housing bubble would never burst and even if a few of these mortgages did default if they were packaged together there was no possible way they would all begin to default. But, the problem does not just lie with lenders. Borrowers banked on the ability to refinance at their current values and when that was impossible when the housing market started to dip. Borrowers too figured that the housing market would never devalue the way it did. This speculation on both sides led to the housing bubble bursting.

The crazy thing about this was the groupthink that occurred on so many different levels. The borrowers, the lenders, and even the large Wall Street firms buying up these mortgage backed securities. They were all speculating that the housing market could never crash the way that it would did. It was the U.S housing market! It would always continue to rise. Well they all missed the signs. Borrowers should have known they should have not been getting the loans that they were getting. Lenders should have been way more careful in who they were giving loans out to. And the buyers of these mortgage backed securities should have done better in researching the credit ratings of the mortgages that backed up these mortgage backed securities and not just taken the word of credit agencies. Because of this, people lost their homes, lenders lost millions, and generational financial firms such as Lehman Brothers and Bear Stearns closed their doors forever.

The housing bubble bursting and the subsequent financial crisis led to universal reform of Wall Street. Laws such as Dodd-Frank were passed in order to regulate Wall Street more closely so that these Financial Firms cannot take on the type of risk that they did in relation to the housing bubble.