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Bubble Redux?

Posted By Barry Ritholtz On October 15, 2003 @ 7:06 am In Finance | Comments Disabled

Astute observation re: the nature of Bubble’s to reinflate.

Mind you, this is not a market call, its merely background color that impacts the overall big picture. And, it consistent with my thesis that this recovery is more of a package of historical government stimulus based than a genuine economic recovery.

That said, this is still a very thought provoking meme:

One of the winners of 2002 Nobel Prize winner in Economics was Dr. Vernon Smith, a professor at George Mason University. One area Dr. Smith studies has been investment bubbles. He has shown that participants in a market consistently produce a bubble and a subsequent crash even when they’re all fully aware of the value of the traded asset.

After going through this exercise where a bubble and a crash occurred, the participants tried it again in a second session. Did they learn anything from their first experience? Sure enough, they produce another bubble and a crash, but this time the bubble was smaller than it was the first time around.

The psychology here is quite simple. Each participant tends to believe he will be more capable of timing the top than the other participants. With experience, each participant tends to react quicker each time to stay ahead of the others. Thus the bubble doesn’t have the chance to grow to quite the same height as previously.

Certainly there are some parallels to the current market situation, but it’s highly unlikely that we will produce an “echo bubble” equivalent to what we saw back in 2000.

The question, though, is how much did participants learn from their experience back then? There were folks who were successful in getting out near the top. How far will they drive us this time? How time-sensitive are investors to this phenomena? Does a four-year period cloud memories? How many new folks are in the market now who didn’t experience what happened back then?

There are lots of interesting considerations, but the main thing to remember is that bubbles tend to repeat.

Attribution note: I’ve seen variations of this in no less than 3 places:

• Rev Shark’s trading diary (Bubble Lessons [1]) whom I owe the above prose to;
• Todd Harrison’s Minyanville [2];
• yet one other site where it was supposedly attributed to Richard Bernstein of Merrill Lynch.

If anyone has a definitive source on this, I’d appreciate it . . .

Update (10/15/03 4:22 pm):
Umair Haque is the mind behind Bubblegeneration [3], a microfilter about strategy and business models. Its a cool blog, and part of my regular readings. Check it out.

Appropriately enough, Bubblegeneration [4] adds to the bubble discussion, with a few well chosen references:

“The seminal references on the computational side is this paper [5] by Brian Arthur, where viral inductive expectations among agents with grossly imperfect information cause most of the behavior we’ve come to know and love in markets, including bubbles.

On the behavioural side, you should check out Vernon Smith [6], particularly this nice pdf intro to experimental economics [7], as well as Richard Thaler’s work, particularly this survey article [8], and, finally, Robert Shiller [9], and his workshops on behavioural finance [10].”


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2003/10/bubble-redux/

URLs in this post:

[1] Bubble Lessons: http://www.thestreet.com/p/dps/td/20031010/tradingdiary3.html#entryId10118706

[2] Minyanville: http://www.minyanville.com/gazette/journal/?id=2630

[3] Bubblegeneration: http://www.bubblegeneration.com/

[4] Bubblegeneration: http://www.bubblegeneration.com/2003_10_12_archives.cfm#106624285613984308

[5] computational side is this paper: http://www.santafe.edu/sfi/publications/wpabstract/199612093

[6] Vernon Smith: http://ices.gmu.edu/people.php/79151.html

[7] experimental economics: http://ices.gmu.edu/pdf/materials/393.pdf

[8] survey article: http://gsbwww.uchicago.edu/fac/richard.thaler/research/survey%20of%20behavorial.pdf

[9] Robert Shiller: http://www.econ.yale.edu/~shiller/

[10] behavioural finance: http://cowles.econ.yale.edu/behfin/bf-2003_04.htm

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