One upshot of the experiments Virginia Postrel has described could be the following: the more investors believe behavioral economics to be true, the more likely bubbles will develop in markets trading in assets. As long as I’m overly confident in my own rationality and knowledge (a bias behavioral economics confirms) and as long as I think everyone else is a moron (my overconfident belief in behavioral economic theory in general) then it will make sense for me to buy assets now in the hopes of selling dearly to others later, when the rising momentum of irrationality has swept them away.
Tag Archives: Finance Bubbles
Meanwhile, Virginia Postrel has a fascinating article in the newest Atlantic on how bubbles develop in finance. She elucidates their nature by describing some recent findings in experimental economics. The nut: it turns out that even fully informed investors will inflate the value of an asset by trying to fleece dummies in the market before it crashes.
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.