Please ensure Javascript is enabled for purposes of website accessibility

What Is the Lollapalooza Effect?

By Motley Fool Staff – Updated Oct 19, 2016 at 1:23PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

It's not just a music festival.

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?

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.

Are you ready to learn more about stocks and how to start investing? Pop over to The Motley Fool's Broker Center and get started today.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now


Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/30/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.