Saturday, December 13, 2008

Even in perfect lab conditions, markets tend towards bubbles

Pop Psychology: Why asset bubbles are a part of the human condition that regulation can't cure

For more than two decades economists have been running this experiment. They take a bunch of volunteers and give each person money and bonds to trade with. The bonds have a risk-free dividend and a clear fundamental value. All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens. Because the bond has a clear dividend, the trading price should stick close to the expected value. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then it crashes. Bubbles happen, even in the most controlled conditions.

Posted by drewster @ 02:15 AM (621 views)
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2 thoughts on “Even in perfect lab conditions, markets tend towards bubbles

  • Thanks for the post – that made interesting reading – something beyond the doom and gloom we often wallow in on this site (oh and I’m one of them as well).

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  • For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.” That’s rarely the case. Rather, “if you put people in asset markets, the first thing they do is not try to figure out the fundamental value. They try to buy low and sell high.”

    This is the crux of it. I did very well in the bubble buying shares which I knew were not worth very much in terms of their potential yield but still selling theme for five or six times what I paid for them. It’s the same when I gamble on the betting exchanges. I don’t bet on who I think will win, I bet where the market has got the price wrong.

    So how does this relate to houses? Well, even when house became overvalued, say 2002, it was right to hold on to property. Those who sold early have lost out. Likewise, there will come a point where houses represent good value again. That is NOT the time to buy because it will not be the bottom of the market. In the short term (which can be several years) market sentiment is what matters.

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