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What causes financial bubbles?

A “financial bubble” is an increase in the price of a financial asset leading to a price tag that doesn’t reflect the asset’s actual value. Investors bid up the price far beyond economic reality as price increases become self-sustaining.

A “financial panic” is a sharp decrease in financial asset prices, which lead to further price drops as panicked investors liquidate their positions.

Many prognosticators take credit for calling the end to a financial bubble or panic after the fact, but few actually call them beforehand.

We humans have ingrained psychologies and physiologies that lead us into investing behaviours that have resulted in financial bubbles and panics throughout our history. It is only recently that we have begun to understand the economic construct of the rational investor is not actual reality.

Psychologists Daniel Kahneman and Amos Tversky questioned the rationality of human decision-making and judgment. This gave rise to behavioural economics, which was the antithesis of the “efficient market” theorists. Kahneman won the Nobel Prize for his work in 2002 and published a book on his research, Thinking Fast and Slow, which described his “Prospect Theory” and the heuristics that human brains use to interpret probabilistic problems. These show that human decision-making uses short cuts (Thinking Fast) that defy logic as well as mathematical constructs (Thinking Slow).

Economist and biochemist John Coates studied the human biochemistry of greed and fear by testing the blood of financial market traders. He concluded in The Hour Between the Dog and Wolf that humans fell under the influence of the hormone testosterone in rising markets. This made them “drunk with success” and encouraged risky behaviours in both their professional and personal lives. He also found that the opposite was true in falling markets where traders were losing money. The increase in the stress hormone cortisol caused traders to be depressed, cut their losses by panicked selling of their positions and fall into an inactive and passive “clinical state.”

Investor behaviors based on human psychology and physiology question the logic of efficient market theory that assumes rational and logical investor behaviours.

Financial bubbles and panics should not occur according to financial theory, yet they arrive with startling frequency. As some market experts remark ruefully, the “once in a thousand years” statistical probability events – predicted by financial theory –is actually occurring every few years. This is a major issue for regulators and risk managers schooled in modern financial theory.

The problem, as economist and former Federal Reserve Chair Alan Greenspan remarked, is that it’s practically impossible to recognize a financial bubble when you are in one.

3 weeks ago

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