Summary
One time in college, I told my housemate he should drop $10 on a Mario mobile game because “You’ve made stupider purchases than that.”
He used this same reasoning to make progressively stupider purchases until he realized that he needed to change his ways.
Smart people often make bad financial decisions when everyone around them is acting irrational.
The best example of this is the dotcom bubble, where investors stopped caring about fundamentals and started pouring money into pretty much every Internet company.
To avoid losing money in a bubble, be self-aware and try writing down the reasoning for your investment decisions.
“You’ve made stupider purchases than that.”
One time in college, my housemate walked into our living room and told me that he was thinking about buying some new Mario mobile game for $10. He thought it looked cool, but he wasn’t sure that it was really worth $10.
“I don’t think it’s a big deal man, it’s just $10,” I told him. I was looking at my laptop and I wasn’t really paying attention to what he was saying. “You’ve probably spent $10 on stupider things than that.”
“Huh, that makes a lot of sense,” he said. He ended up buying the app, but he didn’t stop there. For some reason, “You’ve probably spent $10 on stupider things than that,” really resonated with him. He used that same framework to buy a bunch of other things on Amazon that he didn’t really need. He ended up buying progressively stupider and stupider things until he found himself in his room, surrounded by a bunch of useless shit. He looked around, shook his head in shame, and wondered where his life had gone wrong. Apparently, he never even played that original Mario game that much.
All of that happened because of my terrible advice. Anyway, I’m going to try to make up for what I did by giving you guys some good advice on how you can avoid letting bad influences (like the college version of me) convince you to make bad financial decisions.
Why do smart people make bad decisions?
There’s a reason why the advice I gave my housemate was so terrible. Every purchase decision seems okay if you’re comparing it to the stupidest purchases you’ve ever made. My advice can easily be used to justify purchases that give you a quick hit of instant gratification before you recognize that you made a terrible mistake. Next thing you know, you’re dropping $175 on an Adventure Time Christmas sweater, not realizing that none of the fifty-year-olds at your office holiday party even know the show until you open the package.
Now look, I’m not telling you this story to make fun of my housemate. All of us have held incredibly stupid beliefs at some point in our lives. Usually, we rely on other people to talk us out of whatever ridiculousness we currently have in our heads.
Most of the time, relying on friends and family to stop us from being morons works pretty well. Of course, it doesn’t work when everyone is being stupid. Sometimes, the entire market gets hit with an epidemic of people who are making really bad excuses to chase instant gratification. That’s how bubbles happen.
The dotcom bubble
To get a better idea of how this works, we can take a look at the dotcom bubble of the late 90s and early 2000s.
Back in 1999, the Internet was still relatively new and user numbers were going up exponentially. From 1995 to 1999, it’s estimated that the number of global Internet users went from 16 million to 248 million.
Those numbers made investors very excited. They started pouring huge amounts of money into any Internet company they could find.
The demand for dotcom stocks reached unreal levels. During 1999, the average IPO closed 90% over its offering price on the first day of trading. It didn’t matter how unprofitable or nonsensical your business was, the public markets were still happy to buy your stock.
For example, Webvan, a company that promised to deliver customers groceries in 30 minutes, raised $375 million in a 1999 IPO. Let’s be real — there’s no way any company in the 90s could have delivered on that promise. Even today, Amazon doesn’t offer 30-minute grocery delivery despite the fact they have the most sophisticated delivery operation in the world and own more than 500 Whole Foods stores in North America.
Eventually, reality hit. The tech sector started crashing in the year 2000 when interest rates rose and Wall Street guys started actually looking at the balance sheets of the tech companies they were investing in. They quickly realized that companies like Webvan were unprofitable and didn’t have any viable path to actually start making money. The NASDAQ index, which contains most tech stocks, lost 39% of its value that year. It wouldn’t get back to pre-crash levels until 2015.
As we can all know now, the Internet was a game-changer, and there have been many billion-dollar companies built on top of it. The problem wasn’t that the Internet was all hype — investors who poured money into dotcom companies were just getting way ahead of themselves. While there were a few big winners in that era like Amazon and eBay, lots of other successful Internet companies were still years away. The infrastructure that was needed to actually make the Internet a great place for users and businesses wasn’t there yet — broadband speeds were still incredibly slow in the 90s. Plus, the one innovation that made the Internet a constant presence in people’s lives — the smartphone — wouldn’t become popular until 2007 with the release of the iPhone.
What can we learn from all this?
Even though I was just a kid when the dotcom bubble happened, I can totally imagine what was going through the heads of investors at that time. It’s not easy to stay rational and try to make reasonable decisions when you see all your friends becoming insanely wealthy in just a few months. You get jealous and then you want to jump in. Soon enough, the whole market is driven by the emotions of people who don’t want to be the only person in their friend group who didn’t get rich.
Plus, it’s important to remember that there have been bubbles around exciting new pieces of technology since the dawn of time. Just like the dotcom bubble, there was a bubble in canals in the 1700s and a bubble in railroads in the 1800s. All of these technologies turned out to be a big deal for humanity’s progress as a species. Still, human beings got too excited each time and ended up losing tons of money.
So how do you avoid losing money in a bubble? Here’s a quote from William Bernstein, where he talks about what he would tell someone who’s afraid of getting caught up in a bubble.
I would ask them how empathetic they are. When they see someone around them happy, do they get happy? When they see someone around who is very sad, do they get sad along with them? And if you answer those two questions yes, then you really have to be on your guard, because that tells you that you’re the kind of person who is going to feed off other people’s investing emotions, which is death in investing.
The trick is having as much self-awareness as possible. Personally, I’ve been trying to do that by writing down my investment decisions. Honestly, I could be better about it — I don’t do it as much as I should. Still, it’s the best way to force yourself to look at the reasons why you’re making certain decisions. If you end up losing money, you can always come back to what you wrote to figure out where you went wrong.
In conclusion
My housemate wasn’t the first person who got sucked into really bad financial decisions by the stupidity of the people surrounding him. He’s definitely not going to be the last one either. We all get sucked into bubbles — it’s just human nature. The only way out is through self-awareness.
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How I ruined my housemate's finances