Investment Bubbles

Pop Psychology - Investment Bubbles
12/17/08 - The Atlantic by Virginia Postrel (via Brad DeLong)

A rise in price above a reasonable value (a price bubble), followed by a fall back to that value (a crash), seems to be a part of psychology rather than bad mathematics. Maybe you can avoid losing in the next bubble.

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[edited] Economists have repeated an experiment for 20 years. Experimental groups of about 12 people start with money and shares to trade. The shares pay dividends of 24 cents at the end of each round, for 15 rounds, each round lasting a few minutes. The dividend may be fixed, or have an equal chance of being 0, 8, 28, or 60 cents, averaging to 24 cents. Participants have the same information, can’t talk to one another, and interact only through their trading screens.

The expected (average) value of the remaining dividend payments is 15 x $.24 = $3.60 at the beginning, and of course drops by 24 cents for each round as any dividends are paid. The participants can see the average value of remaining dividends on their computer screens.

There is no doubt about the true value of these dividend payments, no hidden risks or surprise earnings announcements. So, you would think that the trading price should be close to the expected value.

That is not what happens. In 90% of trials, the trading price goes way above expected value, then crashes as the 15th round nears. The participants do not seem to be bored or fooling around. The difference between a good trading performance and a bad one is about $80 in three hours, enough to motivate students to do their best. It seems that asset markets develop bubbles even under the most controlled conditions.

Say that the shares are worth $3.12 at some point according to the dividend payoff. Participants wonder "Can I flip these shares to a buyer who will pay more than I think it’s worth?" As long as a greater fool might pay $3.50, smart people may decide to pay $3.25 in the hope of making a profit.

For a stable price, everyone has to know that everyone is rational, but that is rarely the case. People bidding in an asset market do not immediately try to figure out the fundamental value. Instead, they try to buy low and sell high. That speculation creates a bubble.

The people who stick to fundamentals do not make the most in these experiments. The winners buy a lot at the beginning and sell midway through. They take advantage of “momentum traders” who buy when the market is going up, hold when it is going down, and end with the least money. Bubbles pop when the momentum traders run out of money and can no longer push prices up.

My opinion is that most people like betting and excitement, and they see fluctuating market prices as an opportunity to ride a wave for profits. Twelve students sit at computer screens with a very unexciting situation and a small guaranteed payoff. They can buy and hold shares that will yield $3.60 per share after 3 hours of waiting, or they can buy shares at a slightly higher price on speculation and see what happens.

Say one player buys some shares at 5 cents more than the rational price, and the dividend happens to be larger than usual on that round. Other players see the share price trade up and the payoff that they missed. It is easy to think that there is money to be made by playing the market, playing the desire of others to get into the more active game.

So, a few players buy at a higher price, and sell into an even higher price as others join in. It can seem that higher prices are justified by market activity alone, regardless of the expected value of the dividend. This type of herd-following works for a while until reality sets in. Some players with the right social strategy consistently make money, which gives the feeling that the right price might be higher than just the computed value.

In life, bubbles start when some available commodity, like houses or technology companies, show a steady price gain over a few years. Hope tells people that there just might be a large payoff at the end, even if hard facts make that unlikely. They start to play the wave rather than evaluate the numbers. The price wave is exciting, and the current winners are real. The payoff calculation is on a spreadsheet or envelope, and is only as real as a thought.

So, people think that the price of a house, or Starbucks Coffee, or Krispy Kreme Donuts can only go up, or at worst will sink slowly, allowing them to get out with a profit. But, the price drops suddenly back to reality and there is no getting out.

If you personally do not know what the reasonable, central value is for something, you can't rely on what others are paying, because they probably don't know either.