The trouble with bubbles

Posted by on March 19, 2009 @ 9:02 am in Investing

Bubbles. We’ve just been through two of them in relatively short succession: the Internet bubble of the late 1990s, and the recent housing bubble.

Why do bubbles occur? The list of explanations includes shortsightedness, sheer stupidity, and greed. The history of bubbles is a story of excessive enthuasisms—for anything from tulip bulbs to subprime mortgages.

But is there something more fundamental at work? Something more innate and psychological? It seems to me there is. It arises from who we are as humans, and in how we think and behave, individually and as social animals.

My own theory (drawing on discussions with others) is a relatively simple one. Bubbles begin with simple extrapolation of the recent past. To make decisions, we have to posit some evolution of future events. But why should I take the time to think carefully? It’s much easier to assume that the future will resemble the recent past. What has just taken place will continue to happen—house prices will continue to rise, say, because they have been rising.

As time progresses, these simple extrapolations skew optimistic through a process of selective attention. We push aside possible worst-case outcomes (a historic decline in house prices, for example). They shift out of sight, as our mind is drawn to the more optimistic view of the world. Yes, everyone knows that something might go wrong, and we can all conduct “what if” analyses. But somehow, the worst-case scenarios lose their salience. We explain them all away. (A lack of experience just makes it worse.)

Our thinking is further exaggerated by a phenomenon known as group polarization. Markets are groups of people. In the classic demonstration of group polarization, the aggregate decision of the group (the market) becomes more aggressive or risk-seeking than the views of the individuals involved. (Have you ever come out of a meeting thinking, “The decision we just made as a group is something most of us would individually oppose?” If so, you’ve experienced group polarization.)

To put it simply: Bubble = extrapolation + selective attention + group polarization.

One day, reality intercedes. The hard evidence (say, of falling house prices) becomes overwhelming. The “facts on the ground” begin to contradict our all-too-rosy view of the future. The bubble bursts. By the way, the facts must be overwhelming. There must be a cascading rush of hard data before we can abandon our internal bias toward bubble thinking.

As long as these fundamental processes are at work, bubbles will be with us. The trouble with bubbles? Why, the trouble is us.

Note: We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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