Financial Bubbles

Another day, another sinking stock market. The Dow has officially entered bear territory, which is defined by a drop of 20 percent or more. Many variables are responsible for the financial malaise, from rising gas prices to a weakening job market, but the root cause seems to be the busting of the housing bubble. In retrospect, of course, bubbles are easy to recognize and ridicule. What were all those Wall Street suits thinking when they bought up so much subprime debt? Didn't they realize that the booming real estate market was bound to implode?

And yet, such irrational exuberance is a persistent feature of the economy. In fact, it often seems as we're constantly careening from one bubble to another, from junk bonds to dot-coms to real estate. Do we never learn? Why are irrational market bubbles so alluring to the human brain?

In my latest Seed article (hitting newsstands now! I'll talk about it some more when it goes online), I discuss some research by Read Montague that sheds some light on the issue:

The experiment went like this: each subject was given $100 and some basic information about the "current" state of the stock market. After choosing how much money to invest , the players watched nervously as their investments either rose or fell in value. The game continued for twenty rounds, and the subjects got to keep their earnings. One interesting twist was that, instead of using random simulations of the stock market, Montague relied on distillations of data from famous historical markets. Montague had people "play" the Dow of 1929, the Nasdaq of 1998, the Nikkei of 1986 and the S&P 500 of 1987. This let the scientists monitor the neural responses of investors during real-life bubbles and crashes.

How did the brain deal with the flux of Wall Street? The scientists immediately discovered a strong neural signal that drove many of the investment decisions. The signal was fictive learning. Take, for example, this situation. A player has decided to wager 10 percent of his total portfolio in the market, which is a rather small bet. Then, he watches as the market rises dramatically in value. At this point, the regret signal in the brain - a swell of activity in the ventral caudate, a reward area rich in dopamine neurons - lights up. While people enjoy their profits, their brain is fixated on the profits they missed, figuring out the difference between the best return "that could have been" and the actual return. The more we regret a decision - this resulted in a larger fictive learning signal - the more likely we are to do something different the next time around. As a result, investors in the experiment naturally adapted their investments to the ebb and flow of the market. When markets were booming, such as the Nasdaq bubble of the late 1990's, investors perpetually increased their investments.

But fictive learning isn't always adaptive. Montague argues that these computational signals are also a main cause of financial bubbles. When the market keeps going up, people are naturally led to make larger and larger investments in the boom. And then, just when investors are most convinced that the bubble isn't a bubble - many of Montague's subjects eventually put all of their money into the booming market - the bubble bursts. The Dow sinks, the Nasdaq implodes, the Nikkei collapses. At this point, investors race to dump any assets that are declining in value, as their brain realizes that it made some very expensive prediction errors. That's when you get a financial panic.

Here's hoping that we haven't reached the panic stage yet.

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The WSJ reports that the Fed is considering getting serious about popping financial bubbles: Not so long ago, Federal Reserve officials were confident they knew what to do when they saw bubbles building in prices of stocks, houses or other assets: Nothing. Now, as Fed Chairman Ben Bernanke faces a…
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Given the recent bursting of the housing bubble (let's hope, at least, that we've hit rock bottom), Kevin Drum raises an interesting issue: Bubbles come along with some frequency these days, always with some shiny new reason for bankers to become irrationally exhuberant. Just in the last couple of…

Actually I'm kinda hoping we had the panic stage already.

By NoAstronomer (not verified) on 01 Jul 2008 #permalink

Ditto. After not going into recession (it turned out) the past two quarters I was feeling good that things wouldn't be as bad as feared. But the recent stock market woes makes me think that something else is about to drop. I'm hoping the election (regardless of who wins - although it's Obama's to lose) will get people psychologically feeling confident again.

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Excellent content - as you always provide and inspires me to come again and again.

There is one more valuable resource Id like to share with others readers. Its called Secrets of Successful Traders that teaches you

How to turn $1000 into $ 1MILLION in 5 years or less using nothing but...

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Why market bubbles and markets collpses and flow back and forth and we never learn, perhaps it´s explain because contrary to what people take for granted our emotional (negative) reactions are short-lived as predicted by Daniel Gilbert´s studies on affective forecast (emotional evanescence), and negative emotions (panic) are necessary to stamp the necessary correctness in (economic) behaviour.

Panic don´t last forever and the same errors are committed once again and again, akin to eternal recurrence á la Nietzsche.

...hoping that we haven't reached the panic stage yet.

The demand for oil is too rigid, so the bubble won't explode any time soon. Yet the prices are high enough (almost 600% higher than a few years ago) as to warn extreme caution if you invest in this asset now.

I think these bubbles of oil, food and maybe other primary commodities have actually some real grounds, what is actually more worrying than if they would be just mere speculative bubbles. Making everything more and more expensive is not really the way to push the economy (a capitalist economy based on perpetual growth=consume) ahead, specially when it's already badly injured by the real state bubble.

IMO, what we are witnessing is more than just a series of market bubbles: it's a structural crisis that, if it heals, will take time or radical changes to happen. In brief the global economy has expanded too much for the availability of resources and the purchasing ability of consumers. Unlike raw materials, that are directly overpriced by this structural crisis, real state finds itself like any other secondary product: the offer has overcome the shrinking demand. That's why one bubble exploded (and real state prices still have to fall massively to adapt to a very reduced purchasing power of consumers) while the other, a refuge, looks like rather sustained, at least by the moment. People can live (survive) in a hut maybe but they must eat every day and, so far at least, they also need oil for a lot of things.