How much would you pay for a tulip? And for a nice apartment downtown? What is going on when the market price of such an object is extremely high? Chances are you are facing a market bubble.
At least once in our life, we have heard about the above-mentioned market bubbles. But what exactly are we talking about? Well, it turns out it’s not so easy to define. The most commonly accepted definition is that a bubble occurs when the price of an asset heavily deviates from its fundamental value. Just to cite some examples from the past:
- the tulip mania of the 1630s in Holland was one of the most famous market bubbles and crashes of all time, when the rarest tulip bulbs traded for as much as six times the average person’s annual salary;
- the dot.com mania was a rapid rise in U.S. technology stock equity valuations fueled by investments in Internet-based companies in the late 1990s, which led the Nasdaq to rise from under 1,000 to more than 5,000 between 1995 and 2000 and eventually burst between 2001 and 2002;
- the housing bubble of the 2000s, famously caused by inflowing investments into the housing market, loose lending conditions, and government policy promoting home-ownership.
How behavioral finance explains market bubbles
According to the efficient market hypothesis, all prices are always correct and reflect market fundamentals, i.e. all items that have a direct impact on future income streams of the security. Under this assumption, it would be impossible to explain the existence of speculative bubbles. However, behavioral finance tells us that there are other factors that shape humans’ purchasing and investment decisions.
Even if we have seen so many financial bubbles in the past, it’s extremely hard for some investors to realize they are in one, until it bursts. Let’s see some strong biases that can cloud investors’ judgment to understand why.
- Herd behavior: just like animals, sometimes people tend to follow their peers’ actions. During a speculative bubble, investors mimic the investment decisions of the larger group, the crowd, which in turns leads to self-reinforcing cycles of collective behavior, as many hope to achieve the success earned by early investors.
- Anchoring: investors base their idea of the true value of the asset anchoring on the price such asset is currently trading at.
- Overconfidence: people tend to assume they are smarter than the average, overestimate their capabilities, and convince themselves to have found the key to wealth or to have spotted the trend earlier than anybody else. As investors gain success, they attribute their achievements to intelligence and their failures to bad luck. This illusionary superiority can lead to dangerous risk-taking behaviors.
- Hindsight bias: this relates to overestimate one’s ability to predict future outcomes from experience. In this case, people suppose that, since in the past the price of a certain asset has been going up, it will continue to do so also in the future. Investors often support such forecast more than data would.
- “Greater fool” theory: people will buy into valuations they don’t necessarily find true, just because they believe there will be someone else, of course more foolish than them, they can sell the asset to.
- Confirmation bias: the tendency to ignore the evidence and the signs that one’s pre-formed beliefs are not right and, conversely, to seek confirmation in information that supports one’s decisions. In general, people try to surround themselves with individuals and publications that validate their choices.
Experimental evidence
Emotions play a significant role, not only in the emergence of bubbles but also in their growth. Finance Prof. Terrance Odean, Haas Finance Group, along with Eduardo B. Andrade, Professor at the Brazilian School of Public and Business Administration, and Shengle Lin, Assistant Professor at San Francisco State University, conducted an experiment in 2015 to show how frenzy drives prices upwards.
The experiment consisted in selecting 495 people who were provided with cash and shares of an asset to trade. They were divided into three groups. Each group watched a different video with the aim of inducing in them a different emotion: excitement (high intensity and positive emotion), calm (low intensity and positive emotion), and fear (high intensity and negative emotion). Afterward, their trading behavior was observed. The conclusion drawn was that subjects who traded under the influence of positive emotions were more aggressive and kept pushing prices up until the end of the experiment, whereas those who were conditioned to feel negative emotions acted more cautiously.
Conclusion
To conclude, it’s possible to affirm that emotions and biases shape financial decisions. In order to avoid getting caught in dangerous speculative bubbles, it’s extremely important to always be informed, to keep an open mind, to seek alternative views and, finally, to always be critical in our decision making.
Sources
Shelly Braden (2021, May 11), Understanding the Role of Cognitive Bias and Economic Bubbles, PBMares.com
Behavioral Finance Explains Bubbles, TechCrunch.com (2013, April 20)
Pamela Tom ( 2015, Oct. 28), Stock Market Bubbles: Investor Emotions Fuel the Frenzy, Berkely Haas
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