The Science Behind Market Bubbles
Back on May 23, 2007, the Wall Street Journal talked about Nobel laureate economist Vernon Smith, a George Mason University professor who shared the 2002 Nobel economics prize for his work on how individuals behave in simulated markets. A number of his experiments looked at how investors create market bubbles, how the bubbles pop, and how participants behave afterwards. Dr. Smith found that once investors inflate a bubble and endure a crash, they are unlikely to repeat the mistake until memories fade.
According to the Journal:
In a lab setting, almost any group of subjects, including businessmen studying an executive M.B.A program and professional stock traders, will create a bubble if given adequate cash, Prof. Smith found. In one experiment, where participants could win small amounts of cash by trading successfully, a participant called him over to complain the market was running amok. “He said, ‘What is this buying panic’ ” Professor Smith recalls. Even so, the investor returned to the fray. “He waited a while. Then he started buying.”
Prof. Smith’s experiments show that participants typically inflate a large bubble, cause a crash and then inflate a much smaller bubble, followed by a much smaller decline. After that, they trade cautiously. That helps explain the once-a-generation element of these extra-long bull markets. “Once people get experienced, it is very hard to reignite a bubble with those same people. You’ve got to bring in novices and mix them in,” Prof. Smith says.
So where does that leave us? Did the downturn in the U.S. stock market earlier this decade qualify as the “crash” of a larger market bubble? If so, we may be heading toward yet another decline where investors tread lightly when it comes to equities. Or, are stock investors living on borrowed time before a “once-in-a-generation” market crash ravages Wall Street?
Bubble, bubble, toil, and trouble
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