Crashes
A sharp, rapid fall in asset prices as everyone rushes to sell at once — the mirror image of a bubble, and one of the market anomalies behavioural finance uses to explain what standard theory cannot.
In plain language
A crash is what happens when a bubble bursts. Prices that had been rising sharply reverse. They fall fast, because many holders try to sell at the same time.
The economist Charles Kindleberger wrote a book called Manias, Panics and Crashes. He described bubbles and crashes as mirror images of each other. A bubble is a sharp price rise that feeds on itself, as more buyers pile in. A crash is the sharp fall that follows. Negative news, a change in opinion, or a liquidity crunch sends everyone rushing for the exit at once.
How it works
The workbook's mechanism for a crash runs the bubble process in reverse: "negative news, change in opinion, liquidity crunch, return to fundamental pricing models" pushes traders to want to sell before anyone else does, and that jostling to get out first is what produces the sharp fall.
Why arbitrageurs do not simply correct the mispricing on the way up, preventing the bubble (and so the eventual crash) in the first place: they face a synchronisation problem — coordinating a group sell-off is hard — and differing individual incentives on timing the market during the bubble and crash phases.
The workbook names three historical examples: the Dutch Tulip mania of the 1630s, the South Sea Bubble of 1729-30s, and the Tech bubble of the 2000s. Its illustration of just how badly even a sophisticated investor can misjudge a bubble is Isaac Newton in the South Sea Bubble of 1720: he exited with a profit of GBP 3,500 (selling out at GBP 7,000), then re-entered the market — and ended up losing GBP 20,000 overall. His own verdict: "I can calculate the motions of heavenly bodies, but not the madness of people."
A worked example
The workbook's own illustration, in figures. Newton bought into South Sea Company shares early, and got out at a share price level that gave him a gain of GBP 3,500 — he had exited holding an equivalent of GBP 7,000. Seeing the price keep climbing after he left, he bought back in.
When the bubble finally burst — a crash, in the workbook's own terms — he ended up GBP 20,000 worse off overall, swinging from a realised GBP 3,500 profit to a net GBP 20,000 loss across the full episode. The lesson the workbook draws is not that Newton was foolish — he was, after all, one of history's great minds — but that psychology drove the crash as much as any calculable fundamental, which is exactly the gap behavioural finance exists to explain.
Why NISM asks about it
Chapter 16 (Basics of Behavioural Finance), section 16.6, "Behavioural Finance explains Bubbles and Crashes," covers Kindleberger's framework and the Newton anecdote as its central illustration. Expect a question naming the historical bubble/crash examples, or asking why arbitrageurs fail to correct a bubble before it crashes.
Common exam traps
- A crash is the reverse mechanism of a bubble, not a separate phenomenon — everyone selling at once, rather than everyone buying at once.
- Newton's net outcome was a loss (GBP 20,000), despite an earlier profitable exit (GBP 3,500) — the anecdote is about re-entering after getting out safely, not about never having profited at all.
- Arbitrageurs fail to correct bubbles because of a synchronisation problem and differing incentives, not because the mispricing was invisible to them.
- Short selling being difficult, and the ability to finance purchases by borrowing, are named conditions that help bubbles form in the first place.
Check yourself
1.Behavioural finance studies the influence of psychology on the behaviour of market participants at which level or levels?
- a)Both at the individual and group level
- b)Only at the individual level
- c)Only at the group level
- d)Only at the level of institutional investors
Show the answer
Answer: (a) Both at the individual and group level
The definition states that behavioural finance is the study of the way in which psychology influences the behaviour of market participants both at the individual and group level, and the subsequent effect on the financial markets.
The group level matters: it is what allows behavioural finance to explain herd mentality, bubbles and crashes, and not merely individual mistakes. It is also described as a part of behavioural economics.
Where this is taught
Free preparation for NISM Series X-BRelated terms
- Action biasThe human urge to "do something" even when the best response to a situation is to sit still — in investing, it drives excessive trading, turning what should be a long-term holding into repeated, costly transactions.
- Cognitive errorsStatistical, information-processing or memory mistakes that push an investor away from rational behaviour — one of the two broad families behavioural finance sorts investing biases into.
- Daniel KahnemanThe Nobel laureate, with Amos Tversky, behind Prospect Theory — the framework the workbook uses to explain how investors actually weigh gains and losses, unlike the rational-actor assumption of standard finance.
- Redhead conditionsKeith Redhead's (2008) list of 5 conditions that make a speculative bubble more likely to emerge — inexperienced traders, high valuation uncertainty, asymmetric payoffs, easy borrowing and difficult short selling.