Economics of Speculative Bubbles

A bubble exists when the market price of something is driven well above what it should be, usually due to the herd behaviour of consumers / investors especially in financial markets.

Good examples to quote in exams of speculative bubbles

•TULIP BUBBLE IN THE 17TH CENTURY

•GOLD RUSHES IN THE LATE 19TH CENTURY

•REAL ESTATE (HOUSING) BUBBLES

•DOT COM BOOM FROM 1997-2000

•JAPANESE PROPERTY AND EQUITY BUBBLE

•CRYPTO-CURRENCIES

Five stages of a speculative bubble

1. Displacement stage – excitement grows about a new product / emerging technology
2. Prices boom as demand surges + limited (inelastic) supply causing market prices to spike higher
3. Euphoria as more investors look to take advantage (Robert Shiller calls this “irrational exuberance”)
4. Profit taking stage – some investors sell as they realise prices are out of line with fundamentals
5. Panic – the herd mentality switches to desperate selling and prices fall fast inflicting big losses

Herd behaviour in financial markets

• Herd behaviour is a phenomenon in which individuals act collectively as part of a group, often making decisions as a group that they would not make as an individual.
• Social pressure to conform - individuals want to be accepted – and this means behaving in the same way as others, even if that behaviour goes against your natural instincts.
• Individuals find it hard to believe that a large group could be wrong and follow the group’s behaviour in the mistaken belief that the group knows something an individual doesn’t.
• This is described as the bandwagon effect or group think

The hot hand fallacy and over-confidence

• This is a behavioural bias where someone believes that they are less at risk of a negative event happening to them compared to the rest of the population.
• Traders in financial markets who have made big profits might then under-estimate the probability / risk of a downturn in share prices.
• The hot hand fallacy in short means "whatever is currently happening will continue to happen forever.”
• Traders in financial markets become over-confident, have mistaken valuations and believe them too strongly. Investors credit their own talents and abilities for past successes.

Prospect theory and speculative bubbles

• A theory of human behaviour under uncertainty
• As a market goes up, people become less risk averse and become more willing to gamble
• This accelerates the rate of increase of asset prices
• Investors also suffer from loss aversion
• When asset prices start falling, many are initially reluctant to sell because that might crystalize a loss
• They hold on their investments for too long – before panic selling sets in and prices fall rapidly