What Is the Lollapalooza Effect?

Charlie Munger, an American businessman, investor, and partner of the legendary Warren Buffett, coined the term "Lollapalooza effect" during a 1995 Harvard speech, in which he reviewed numerous causes of human misjudgment. It has since become another piece of investing jargon.

So what does this term actually mean, and why is it important for investors to understand?

Definition
We humans have many inherent biases and tendencies that can sway our behavior one way or another. When several of them act in concert to drive us toward a particular action, you have a Lollapalooza effect. The Lollapalooza effect can create large-scale drivers of human behavior -- and often error.

What it means in the real world
Though the Lollapalooza effect is often shown in a bad light, it can have both positive and negative outcomes. One positive example of the Lollapalooza effect is the Alcoholics Anonymous program, which, as Munger explains, boasts a no-drinking rate of 50% in cases where all other social and health-related factors fail to motivate alcohol abusers to quit. Munger hails Alcoholics Anonymous as a clever system that makes constructive use of people's psychological tendencies. For example, one reason AA often works is people's natural tendency to imitate those around them. AA members are surrounded by people who have fought to become sober, which makes newer members more likely to follow suit.

On the other hand, Munger also points to the open auction system as a negative example of the Lollapalooza effect. He believes that in this environment, several psychological biases converge, causing people to act foolishly. Namely, the psychological phenomenon known as "social proof" leads people to imitate the actions of others in an effort to reflect seemingly appropriate behavior. As a result, during an auction, participants will often engage in bidding wars because that's what the people around them are doing -- not because they're passionate about acquiring the item up for auction, or because they've drawn the logical conclusion that they're offering a good price for the item. 

The Lollapalooza effect can also apply to investing, causing millions of investors to buy one sector, sell off another sector, or otherwise act as a "herd." This herd mentality is every investor's worst enemy. After all, if you sell when everyone else is selling, then you're probably eating huge losses. If you do the opposite and buy when everyone else is selling, then you're likely getting bargain prices for your shares. So, before you make an investment, it's wise to think about how different psychological factors might be causing an irrational reaction in the market.

The Lollapalooza effect and the mortgage crisis
The 2007-2008 mortgage crisis is a textbook example of the Lollapalooza effect. Before the mortgage market imploded, brokers were highly motivated to sell home loans, because the more they sold, the more money they earned. They had once been more concerned about the creditworthiness of borrowers, as lenders had a practice of keeping mortgages on their books and thus stood to lose a great deal in the event of a loan default. However, when Wall Street introduced the concept of selling mortgages to the financial markets, it created a gigantic Lollapalooza effect.

Suddenly every player in the market had a different motivation: Brokers wanted to make money, investors who bought the mortgages wanted to make money, banks wanted to make money, and borrowers wanted to purchase their dream homes regardless of whether they could actually afford them. No single player thought about the long-term consequences, and as a result, the mortgage market collapsed because of an overwhelming dose of human misjudgment.

As an investor, it's important to recognize when a Lollapalooza effect might come into play. When various complex scenarios and competing motivations converge, it can result in a volatile situation. Achieving success as an investor is often a matter of avoiding situations that are extremely difficult to predict due to the number of moving pieces involved. In other words, if there's no good way to determine whether an investment is a smart one, then you may be better off staying away.

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