Wednesday, July 16, 2014

Bubbles, Booms, and Busts: Why Rational Investors Become Irrational

The recent post distinguished between financial bubbles and manias, suggesting that blowoff tops and eventual crashes occur when overpriced assets--instead of returning to fair value--become the object of frenzied speculation.  The above graphic from Jean-Paul Rodrigue captures this dynamic quite nicely, suggesting that the phases of blowoff and crash are accompanied by participation from different segments of investors.  Enthusiasm, he suggests, turns to greed and eventually to the delusion that we are living in a new paradigm.

This dynamic has caught the attention of researchers, as it is so completely at odds with the common view of efficient markets and rational investors.  Indeed, Rodrigue refers to bubbles as "misallocation engines", as lax credit provides the fuel for the paradoxical situation in which higher asset prices lead to greater investor demand.  Hence the phenomenon of rising volatility and volumes even as prices move higher, noted in the previous post.

In 2007, I cited the momentum life cycle work of Lee and Swaminathan, which suggested that there are common patterns linking share prices and volumes.  Specifically, stocks go through phases of rising volume, which correspond to short-term momentum effects (strength leading to further strength) and longer-term reversals (strength leading to correction).  Following such corrections, stocks typically show low volume characteristics and behave in a value (mean-reversion) manner, rather than a momentum one.  These momentum life cycles help to explain why value and momentum strategies work--and why each does not work uniformly.  

From this perspective, the bubbles researched by Kindleberger might represent exaggerations of the normal cyclical behavior of assets. The role of lax credit in these exaggerations would help to explain why, in the wake of low interest rates policies across the globe, Colombo finds current evidence of bubbles across multiple markets and regions.

Recent research suggests that the dynamics underlying the transition from normal, cyclical behavior to bubble creation may lie in the brain.  Participants in a simulated trading market underwent brain scans via fMRI while trading that market.  Overall, participants displayed activity in the pleasure centers of the brain as prices rose.  Successful participants, however, received a warning signal from the brain when a market was in its manic phase, leading them to exit before boom led to bust.  Less successful participants did not receive such a signal and continued to act on their pleasure signals well after the market had turned.

Colin Camerer, researcher behind the study, noted that subjects were able to control the prices of the simulated assets through their decisions.  "The first thing we saw," he noted, "was that even in an environment where you don't have squawking heads and all kinds of other information being fed to people, you can get bubbles just through pricing dynamics that occur naturally."  Interestingly, the lowest earning group of traders in the study were momentum participants who consistently acted on their brains' pleasure signals.  The best performing group bought early and sold while prices were still on the rise.

To return to the above graphic from Rodrigue, successful traders behaved more like the "smart money", while unsuccessful traders acted like the uninformed public, valuing the market more as its valuation rose.  It is in this context that the advice of Abnormal Returns, to stand aside from bubble prediction and participation, makes good sense.  What gratifies our pleasure centers is not necessarily what makes us profitable.

Still, as Tadas notes, citing Daniel Gross, there can be an upside to bubbles in the broader scheme of things:  boom and bust in the short run--from gold rush frenzies to dot-com speculation--provide funding for frontier efforts that eventually lead to real development.  Not all infatuations lead to lasting romance and not all speculations end in long-term, profitable investments.  Without animal spirits, however, perhaps many frontiers would remain unexplored and undeveloped.  

Further Reading:  Why Emotions Are Key to Trading Performance