On the origin of bubbles

Posted by on March 23, 2011 @ 8:50 am in Investing

I was traveling a few weeks ago to visit with institutional clients. For my travel reading, I downloaded Michael Lewis’s The Big Short. It’s a colorful look at some of the personalities during the great financial crisis of 2008–2009—in particular, the handful of market participants who saw the crisis coming.

I’ve been thinking a great deal about the dynamics of asset price bubbles, like the mortgage crisis or the internet stock craze. Recently I issued a Vanguard research paper sketching out a psychological model that might underlie the formation of bubbles. To put the paper’s argument in a simple way: The fundamental cause of bubbles seems to be a form of group self-delusion. Many (but not all) market participants develop a view of the future that is wholly unrealistic, and they disseminate this idea widely throughout the financial markets.

The essence of a market bubble is that it is a group or social phenomenon. And because it has psychological origins, technological improvements in the financial system over the years—such as improved market data, risk modeling, securities design, or even our own understanding of statistics—are not particularly helpful in combating bubble behavior. Indeed, you could argue that modern finance technology simply amplifies bubble tendencies.

When I was young, I remember learning about lemmings, the curious creatures who would occasionally, and inexplicably, plunge off the cliffs of Scandinavia into the sea to their deaths. I have since learned that this story is largely a myth. But it still stands as a metaphor for market bubbles. Occasionally, and somewhat inexplicably, financial market participants are prone to engage in self-destructive behavior, whether in the market for stocks, mortgages, or other assets. Such fluctuations almost seem inevitable, and so investors need the patience and fortitude to look beyond them.

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