Senior Seminar December 2015 Bubbles

An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is

"trade in high volumes at prices that are considerably at variance with intrinsic values".

It could also be described as a situation in which asset prices appear to be based on implausible or inconsistent views about the future.

The two most famous bubbles of the twentieth century, the bubble in American stocks in the 1920s just before the Great Depression and the Dot-com bubble of the late 1990s were based on speculative activity surrounding the development of new technologies. The 1920s saw the widespread introduction of an amazing range of technological innovations including radio, automobiles, aviation and the deployment of electrical power grids. The 1990s was the decade when Internet and e-commerce technologies emerged.

Emotional and cognitive biases seem to be the causes of bubbles, but often, when the phenomenon appears, pundits try to find a rationale, so as not to be against the crowd. Thus, sometimes, people will dismiss concerns about overpriced markets by citing a new economy where the old stock valuation rules may no longer apply. (“This time its different”…but human psychology has not really changed! Mr. B) This type of thinking helps to further propagate the bubble whereby everyone is investing with the intent of finding a greater fool (The “greater fool theory”).

A rising price on any share will attract the attention of investors. Not all of those investors are willing or interested in studying the intrinsics of the share and for such people the rising price itself is reason enough to invest. In turn, the additional investment will provide buoyancy to the price, thus completing a positive feedback loop.

Like all dynamic systems, financial markets operate in an ever changing equilibrium, which translates into price volatility. However, a self-adjustment (negative feedback) takes place normally: when prices rise more people are encouraged to sell, while fewer are encouraged to buy. This puts a limit on volatility. However, once positive feedback takes over, the market, like all systems with positive feedback, enters a state of increasing disequilibrium. This can be seen in financial bubbles where asset prices rapidly spike upwards far beyond what could be considered the rational "economic value", only to fall rapidly afterwards.

Effect of incentives

Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. This exacerbates the risk for investment managers that do not participate during the building phase of a bubble, particularly one that builds over a longer period of time. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits.