Monday, December 15, 2008

Foolish bubbles 

A very good bond trader once told me more than a decade ago that he made more money on the Greater Fool Theory than any other theory of finance he knew. I'm reminded of this in Virginia Postrel's essay in the Atlantic:

Experimental bubbles are particularly surprising because in laboratory markets that mimic the production of goods and services, prices rise and fall as economic theory predicts, reaching a neat equilibrium where supply meets demand. But like real-world purchasers of haircuts or refrigerators, buyers in those markets need to know only how much they themselves value the good. If the price is less than the value to you, you buy. If not, you don�t, and vice versa for sellers.

Financial assets, whether in the lab or the real world, are trickier to judge: Can I flip this security to a buyer who will pay more than I think it�s worth? In an experimental market, where the value of the security is clearly specified, �worth� shouldn�t vary with taste, cash needs, or risk calculations. Based on future dividends, you know for sure that the security�s current value is, say, $3.12. But�here�s the wrinkle�you don�t know that I�m as savvy as you are. Maybe I�m confused. Even if I�m not, you don�t know whether I know that you know it�s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn�t matter that we know the security is worth $3.12. 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.� That speculation creates a bubble.

In fact, the people who make the most money in these experiments aren�t the ones who stick to fundamentals. They�re the speculators who buy a lot at the beginning and sell midway through, taking advantage of �momentum traders� who jump in when the market is going up, don�t sell until it�s going down, and wind up with the least money at the end. (�I have a lot of relatives and friends who are momentum traders,� comments Noussair.) Bubbles start to pop when the momentum traders run out of money and can no longer push prices up.

Bubbles disappear when people learn, which is why bubbles seem to be more prevalent in assets for which there's little history for the buyer or seller to gauge fundamentals from.