It may be most commonly known as the name of a music festival, but the word "Lollapalooza" has its origins in 19th-century American slang. It refers to "an extraordinary or unusual thing, person, or event; an exceptional example or instance." Veteran market-watchers will also associate it with the late Charlie Munger, one of the best-known U.S. investors in recent memory. Let's dive in and explore what's become known as the "Lollapalooza effect."
The Lollapalooza effect and markets
Munger said that one of the best examples of the Lollapalooza effect is open auctions.
At least three tendencies lead to trouble:
- Social proof, or other people's influence
- Reciprocation tendency, or the likelihood that people will act as others expect them to
- Deprival super reaction syndrome, or the threatened removal of a scarce resource
"Three, four, five of these things work together," Munger said, "and it turns human brains into mush. And maybe you think this doesn't happen in picking investments. If so, you're living in a different world than I am."
Munger's description of the Lollapalooza effect took on extra credence during the 2007-09 financial crisis when it appeared in full swing. The crisis was caused largely by Wall Street's decision to push subprime mortgage-backed securities as investments.
Brokers were financially incentivized to sell securities regardless of their soundness. Banks were incentivized to make subprime loans to be packaged and sold to brokers. Consumers were incentivized to buy houses they couldn't afford, whether for investments or homes. Eventually, the housing market collapsed, caused by multiple factors working together, leading to a prolonged global economic slump.
Identifying all the potential Lollapalooza effects is no easy task. However, it's safe to say that if more than a few exist, an investment will likely be extremely volatile and unpredictable, and it might be best to avoid potential trouble.
