Yes, you heard it right, the Lollapalooza Effect, and I am sure many of you have never heard about it. It may sound a bit strange, but it holds much importance for an intelligent investor.
First of all, we will discuss What the Lollapalooza Effect is?
It is nothing but A phenomenon where multiple human biases, acting in a concerted way, produce a large, extreme result.
The term was first tossed in 1995, during a Harvard speech on the topic “The Psychology of Human misjudgment”, by American billionaire investor Charlie Munger who is also a partner of legendary investor Warren Buffett. Mr Munger cited Coca-Cola’s dominance in the worldwide soft drink market as an example of the Lollapalooza effect. Since then, it has become investment jargon.
Only by knowing what it is, you might be able to recognise when you are falling for it.
Sir Isaac Newton was a genius. Yet, even revolutionary thinkers make stupid mistakes. After all, he is also a human being, just like you and me. Newton enhanced our understanding of light and came up with the laws of gravity, calculus, but he also invested in something called the South Sea Company.
A very famous investment incident relates how Isaac Newton, after cashing in large early gains, staked his fortune on the success of the South Sea Company in 1720 and lost heavily in the ensuing crash. Tales abound of how he invested early and cashed out with 100% profits as market valuations went to what seemed to him unjustified levels. However, as prices continued to advance, he supposedly invested again at the peak and lost most of his fortune in the crash that followed.
That a person of such ability, knowledge and connections could lose his head in mania is therefore frequently cited as an example of the difficulty of recognising bubbles. Instead, the company turned into a get rich quick scheme. The hype around the firm grew to epic proportions, and investors quickly piled in. The stock price skyrocketed. As the price got higher and higher, more and more people started to jump in on the bandwagon. One of these was the famed scientist Isaac Newton.
In fact, there is a quote attributed to him that says: “I can calculate the motions of the heavenly bodies, but not the madness of people.”
What the Madness of people/crowd is?
What Charlie said in 1995, Twelve years later, the financial crisis of 2007-08 exposed the mental failure for everyone.
Charlie Munger observed that the outcome that arises is the result of not just one but several psychological tendencies working at a time. He called it the Lollapalooza Effect. This happens when several different biases combine to sway a person to pursue a particular course of action.
For example, you might have some preconceived notions about a subject. Then you find a story that confirms this. Your brain acts in a way to only pay attention to the evidence that you like and discards all the rest.
In his speech at Harvard, Charlie Munger listed several tendencies that often lead to human misjudgment. These include behaviour based on misplaced incentives, liking and loving a certain person or thing, or a tendency to avoid doubt.
Can you think, what is the similarity in all these three cases?
1 Smartphone’s Flash Sales.
2 Coca cola’s dominance.
3 Subprime crisis.
You might be confused that what is the similarity between all three?
All of the cases are the best example of the Lollapalooza Effect. Now we are getting into the detail of how it is.
1. Smartphone’s Flash Sale:
Almost all the popular brands of a smartphone are launching new models by Flash sales why?
Smartphone brands often use flash sales for quickly offloading inventory and increase brand awareness.
Suppose you want to buy a newly launched smartphone, but you wonder whether or not to buy it at the current price. While you are struggling with this decision, the phone company announces that this particular model will be online exclusive and sold through flash sales. In such circumstances, your decision could be affected by several psychological scenarios that come into play:
a. Authority Bias: Companies often distribute a few samples to popular reviewers before launching a new model. These types of reviews often influence our decisions.
b. Social Proof: Thousands of people are buying a smartphone, then the product might be good.
c. FOMO: If the phone is sold out during a flash sale, I will be missing the opportunity to get the smartphone earlier.
d. Envy: If someone could not buy a smartphone, and his close friend bought it in the sale. What would be the person’s reaction? He will try harder to buy it in the next flash sale definitely.
This case shows that when a couple of factors operate together in the same direction, the result could be extremely positive (or negative).
Now come to 2nd case.
2. Coca-cola’s dominance:
We learnt from the previous case that exponential results occur when multiple forces operate in the same direction.
So, which factors have worked in favour of Coca-cola?
At least three factors have worked together to generate extraordinary results for Coca-Cola.
a. Pavlovian conditioning: Pavlovian conditioning theory implies learning a new behaviour through the process of association. Remember how the mere ringing of a bell caused Pavlov’s dog to salivate?
Similarly, the association of Coca-Cola consumption with events we attend and celebrities, Sports Stars or movie stars or supermodels, we admire creates Pavlovian conditioning.
b. Availability Bias: We tend to make decisions based on readily available information. When we are repeatedly exposed to a particular product or idea through interaction or advertising, it is stored in our minds, waiting to be recalled at a moment’s notice.
c. Social Proof: Social proof is basically herd instinct – the more individuals follow a certain idea/behaviour, the better we consider the idea to be! Similarly, imitative consumption of Coke triggered by the mere sight of consumption of Coke reinforces the “social proof” factor for Coke consumers.
Therefore, Pavlovian conditioning, Availability Bias, and Social Proof have worked in tandem to create a compounded effect that creates and maintains a competitive advantage for Coca-Cola and created a lollapalooza effect.
Let us check the 3rd case.
3. Subprime crisis
The subprime crisis of 2007-08 is the best example of the Lollapalooza Effect. Before the advent of securitization, lenders used to keep mortgages on their books. Hence, they were concerned about the creditworthiness of the borrower. After wall street came up with the concept of securitization, it created a massive Lollapalooza effect. Securitization allowed lenders to sell their mortgages to the street, which would then bundle and sell them to investors around the globe.
As a result, the mortgage lending business was transformed from a long-term affair to an assembly-line process, where lenders could clear all risks from their books to get paid faster and issue more loans. From frontline real estate brokers to appraisers, mortgage lenders, banks and borrowers, the entire system was affected by a lethal dose of human misjudgment.
a. Incentive Bias: Frontline real-estate agents were incentivized to sell more to earn more commission. They were keen to make more money, even if those sales weren’t profitable, in worst cases, against the long-term interest of the investor.
b. Social Proof: Borrowers were affected by herd instinct.
c. Bandwagon Effect: As real estate prices rose; everybody was buying houses; even those who couldn’t afford to took loans to support an unsustainable lifestyle; some become speculators, switching homes, trying to make a killing as real estate prices kept rising.
What was the outcome?
The Lollapalooza effect brought the global economic meltdown.
Next time we will discuss “How the Lollapalooza Effect is affecting the current market? and what are the solutions?”
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