Normalcy Bias Example: The Perils of Buying at the Peak

Normalcy Bias Example: How Timing Ignorance Leads to Financial Ruin

Aug 8, 2024

Human psychology plays a pivotal role, often leading to patterns of behaviour that defy logic and reason. One such psychological phenomenon, the normalcy bias, has been a recurring theme throughout the history of investing, causing countless individuals to fall into the trap of buying at market peaks and selling at troughs. This essay delves into the depths of this cognitive bias, exploring its manifestations in various market scenarios and drawing insights from mass psychology, contrarian investing, the bandwagon effect, and technical analysis.

The Siren Song of Normalcy Bias

Normalcy bias, also known as negative panic or ostrich effect, is a cognitive bias that causes people to underestimate the likelihood of a disaster occurring and its potential adverse effects. In investing, this translates to a stubborn belief that markets will continue to behave as they have in the recent past, even in the face of mounting evidence.

As the 18th-century satirist Jonathan Swift stated, “It is useless to attempt to reason a man out of a thing he was never reasoned into.” This sentiment perfectly encapsulates the grip that normalcy bias has on investors’ minds. When markets are soaring, the intoxicating euphoria of ever-increasing profits blinds many to the warning signs of an impending downturn.

Consider the dot-com bubble of the late 1990s. As internet-based companies saw their valuations skyrocket, investors poured money into stocks with little regard for fundamentals. The prevailing belief was that the “new economy” had rendered traditional valuation metrics obsolete. This normalcy bias led countless investors to buy at the peak, only to watch their investments evaporate when the bubble burst in 2000.

The Scottish economist and financier John Law provides an earlier example of normalcy bias in action. His Mississippi Company scheme in early 18th century France created a speculative frenzy that saw stock prices rise to astronomical levels. Blinded by the promise of endless riches, investors continued to buy even as the underlying economic reality became increasingly unsustainable.

The Herd Mentality: When Donkeys Learn Nothing from History

The bandwagon effect, a close cousin of normalcy bias, further exacerbates the tendency to buy at market peaks. This psychological phenomenon occurs when people do something primarily because others do it, regardless of their beliefs or analysis. In financial markets, this manifests as investors piling into popular stocks or asset classes simply because “everyone else is doing it.”

As the great contrarian investor Nathan Rothschild famously said, “Buy when there’s blood in the streets, even if the blood is your own.” Yet, time and again, we witness the masses doing precisely the opposite. Like a herd of donkeys, as satirist H.L. Mencken might quip, investors seem to learn nothing from history.

The cryptocurrency boom of 2017 serves as a prime example. A buying frenzy ensued as Bitcoin and other digital currencies saw their values soar. Individuals with little understanding of blockchain technology or cryptocurrency fundamentals rushed to invest, driven by the fear of missing out (FOMO) and the belief that prices would continue to rise indefinitely. When the bubble burst in 2018, many were left holding assets worth a fraction of their purchase price.

Technical Analysis: The Writing on the Wall

While mass psychology and the bandwagon effect explain why investors fall prey to normalcy bias, technical analysis provides tools to identify potential market tops and bottoms. Yet, even with these indicators at their disposal, many investors ignore the warning signs, preferring to cling to their biased perceptions of market normalcy.

The Relative Strength Index (RSI), a momentum indicator used in technical analysis, often signals overbought conditions before significant market corrections. However, during highly bullish times, these signals are frequently dismissed as irrelevant in the face of a “new paradigm.” This willful blindness to technical indicators is another manifestation of normalcy bias in action.

Contrarian Investing: Swimming Against the Tide

Contrarian investing, the practice of going against prevailing market trends, offers a potential antidote to the perils of normalcy bias. By actively seeking opportunities that counter the prevailing sentiment, contrarian investors aim to capitalize on the market’s tendency to overreact in both directions.

Bernard Baruch, one of the most successful speculators of the early 20th century, embodied the contrarian spirit. He famously said, “The main purpose of the stock market is to make fools of as many men as possible.” Baruch’s success came from his ability to remain level-headed and objective in the face of market euphoria or panic. This trait allowed him to buy low and sell high consistently.

The observations of Ibn Battuta, the 14th-century Moroccan scholar and explorer, further support the wisdom of contrarian investing. Though not an investor himself, Battuta’s extensive travels led him to observe that “Traveling – it leaves you speechless, then turns you into a storyteller.” In investing, this insight reminds us of the importance of seeking diverse perspectives and challenging our biases – a key tenet of contrarian thinking.

Breaking Free from the Normalcy Bias Trap

To avoid falling victim to normalcy bias and the perils of buying at market peaks, investors must cultivate a mindset of critical thinking and emotional detachment. This involves:

1. Embracing scepticism: Question prevailing narratives and be wary of claims that “this time it’s different.”

2. Studying market history: Familiarize yourself with past bubbles and crashes to recognize patterns and avoid repeating mistakes.

3. Developing a contrarian streak: Be willing to go against the crowd when your analysis suggests it’s the right move.

4. Utilizing technical analysis: Pay attention to indicators that may signal overbought or oversold conditions.

5. Practicing patience: Resist the urge to jump on every trending investment opportunity.

6. Diversifying: Spread investments across various asset classes to mitigate the impact of any single market downturn.

The Road Less Traveled: Wisdom from Satirists and Sages

As we navigate the treacherous waters of financial markets, we would do well to heed the words of satirists and sages who have long observed human folly. The quintessential American satirist, Mark Twain, once quipped, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that ain’t so.” This sentiment perfectly encapsulates the danger of normalcy bias in investing.

Similarly, the Roman philosopher Seneca observed, “It is not because things are difficult that we do not dare; it is because we do not dare that things are difficult.” Applied to investing, this wisdom encourages us to challenge our assumptions and step outside our comfort zones – essential steps in overcoming normalcy bias.

Conclusion: Vigilance in the Face of Market Euphoria

As we’ve explored throughout this essay, normalcy bias remains a persistent threat to investors, luring them into the dangerous trap of buying at market peaks. By understanding the psychological underpinnings of this phenomenon and arming ourselves with insights from contrarian thinkers, technical analysis, and historical examples, we can better navigate the complex world of financial markets.

Remember, as the markets ebb and flow, not the strongest or the most intelligent survive, but those most responsive to change. By remaining vigilant, questioning our assumptions, and learning from the wisdom of those who have come before us, we can hope to avoid the fate of those who, like donkeys led to slaughter, blindly follow the herd over the cliff of financial ruin.

Ultimately, successful investing is not about predicting the future but preparing for it. By cultivating a mindset that embraces uncertainty and challenges prevailing wisdom, we can position ourselves to capitalize on opportunities that others, blinded by normalcy bias, fail to see. As we move forward in an ever-changing financial landscape, let us strive to be the contrarians, the sceptics, and the clear-eyed observers who can see beyond the illusion of normalcy and chart a course towards true financial wisdom.