27 November 2009

Blowing Bubbles

Bubbles in financial markets [the image is a 1997 cover from the Economist] will not go away, and that's upsetting to "rational expectations" and "efficient market hypothesis" economists.*

Fortunately, experimental economists have looked into the question, reproducing bubbles in the laboratory and playing with the factors that drive bubbles.

Both Vernon Smith and Charlie Plott have contributed to this research.

In this 2003 paper [pdf], Porter and Smith review experiments that look at bubbles and conclude that:
bubbles seem to be due to uncertainty about the behavior of others, not to uncertainty about dividends... futures markets help to dampen (but do not eliminate) bubbles... limit price change rules make bubbles worse.
In this 2002 paper, Plott et al. [pdf] find... "that errors in decision-making [not speculation] are a primary source of bubbles."

In sum, then, bubbles form when someone guesses high (makes a mistake) and someone follows. They form for assets (not consumption goods), because asset values depend on people's opinions on future value. Note that short sellers can dampen bubbles, but only if they turn the market before they are buried by a wall of "dumb" money.

Bottom Line: We cannot ban bubbles in the same way as we cannot ban celebrity gossip. All we can do is protect ourselves (if you don't get in, you don't have to worry about getting out) and protect others (money managers should be fired -- or worse -- for trying to time bubbles with other people's money).

* (via BB), John Mauldin writes a scathing critique of EMH.

7 comments:

Josh said...

Good post. I've got a lesser-known, but more apt, quotation from Keynes on bubbles and the efficient market:

"The market can stay irrational longer than you can stay solvent."

WaterSource said...

Having just returned from the Dubai bubble, " build" and "breed" should be added to the cartoon ! Dubai looks like China on steroids and rodents would be hard pressed to keep up with the reproduction of 15+ offspring per family.

Desalination and the price of domestic water at 4X the price of gasoline hasn't stopped the price in the Burj Dubai from attaining $4000 US per square foot.

With temperatures averaging well over a 100F for many months of the year, only the rich and famous companies of the world would choose such an unlikely place to BLOW such an outrageous, over the top glitzy bubble ... unless it is Qatar which at least has the oil and natural gas to support a trillion dollar party in the man-made "Pearl" without any alcohol, girls or gaming !

Eric said...

If you are a money manager and you refuse to follow bubbles, don't you get fired for not producing a good enough return?

Eric said...

Thanks for this post. I needed to find references on exactly this topic. The links are really useful.

tidal said...

The EMH critique is by James Montier, not Mauldin. Mauldin seldom actually writes anything, and would not be capable of writing the piece you reference. The piece itself is entertaining, but he does not make a particularly novel or strong case. And I am not defending EMH. My point is that there are stronger challenges than this one, which is quite weak.

In particular, I am not sure it's reasonable to use "bubbles" as a case against EMH in general. I think it is Paul Samuelson who said that markets seem to be micro-efficient and macro-efficient.

tidal said...

oops, the Samuelson reference should read micro-efficient and macro-inefficient...

David Zetland said...

@Josh -- yes, perfect quotation.

@WS -- fools and their money are soon parted :)

@Eric -- yes, and that's a problem with their compensation. Note that reversion to the mean often follows hires/fires.

@Tidal -- well, then, you are accusing Maudlin of plagiarism: http://www.ritholtz.com/blog/2009/08/six-impossible-things-before-breakfast/ -- and *agreed* on micro/macro.