The psychology of crowds plays a significant role in driving market bubbles from "summary" of A Short History of Financial Euphoria by John Kenneth Galbraith
The psychology of crowds is a subject of profound importance in the financial world. It is through the collective behavior and emotions of individuals that market bubbles are formed and sustained. When a group of people become convinced that a particular asset is on an upward trajectory, they tend to disregard rational analysis and simply follow the crowd. The power of this collective mindset is such that it can lead to exuberant market conditions where prices are driven to unsustainable levels. In the midst of a bubble, investors are often guided by the fear of missing out and the desire to profit from the continued rise in prices. This herd mentality can cause rational decision-making to be thrown out the window. One of the key reasons why market bubbles occur is the inherent human tendency towards greed and overconfidence. In the midst of a euphoric market environment, investors often believe that they are invincible and that the good times will continue indefinitely. This creates a self-reinforcing cycle where rising prices attract more investors, further driving up the price of the asset in question. As the bubble continues to inflate, the disconnect between the underlying value of the asset and its market price becomes more pronounced. This leads to a situation where the bubble is bound to burst at some point, causing significant financial losses for those who were caught up in the frenzy. In the aftermath of a market bubble, there is often a period of panic and despair as investors realize the extent of their losses. The psychology of crowds shifts from exuberance to fear, leading to a sharp decline in prices and a rush to sell off assets. This cycle of boom and bust is a recurring feature of financial markets, driven by the collective behavior of individuals caught up in the euphoria of a market bubble.
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