Financial Bubbles – Human Behavior & Risk Management

Someone in linkedin asked how human behavior contribute to financial bubbles and how to manage such risk.  Here is my answer:

If you think of a bubble being the consequence of inefficiencies in the market, then we can examine how the two premise of efficient market theory can be broken:

1. Misinformation. Academics assumes perfect information to make their models work. In reality, misinformation is everywhere. To be more precise, misinformation is greatest when something is new. That’s why bubbles are always associated with innovation or “new concept”. The fact that no one can accurately value “new paradigms” (ie. dot-com technologies, sub-prime derivatives, etc) leads to bad investment decisions.

2. Irrationality. Academics assume people to make rational decisions based on perfect information. The perfect information part is addressed above. Rationality is also challenged when misinformation is rampant, because now people have to rely more on “gut feelings”. When emotion becomes the vehicle for decision making due to the lack of predictability of “new paradigms”, greed and fear lose balance. The imbalances are small at the beginning, and often go away as more accurate information unravels. In rare cases, the misinformation persists because innovations become more complicated, and rising asset prices reinforce the greed, then people start attributing their success on their own intellect … and a real bubble is born. Self-proclaimed “Experts” would start to write books and show on TV to “teach” others how to get rich, effectively worsening the misinformation. Then you have the academic bunch who believe that “the market is always right” writes papers about “how this time is different”. The politicians cheer at their success of creating “prosperity”.

It’s about time when envy kicks in and everyone becomes invested.

When everyone wants to invest becomes invested, the prices start to go down ….. and BOOM !