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What Is An Asset Bubble And Several Behavioural Factors Leading To A Speculative Bubble

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In 1593 when the tulip was first brought to Holland, people must have never thought that this flower would one day set in such an extreme madness. At the peak when everyone was trying to obtain the tulip bulbs, the cost of a single Semper Augustus was said to be enough to feed, clothe, and house a whole Dutch family for half a lifetime (Dash, 1999). The sudden plunge in 1637 finally put an end to the passion of people over the tulip, which later on was also recorded as one of the earliest irrational asset bubbles.

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Almost a century after that, the very first speculative bubbles on stock markets simultaneously happened in England and France, called the South Sea Bubble and the Mississippi Bubble, respectively. When the South Sea Company was newly established in 1711, its founders decided to take on a government debt of £10 million in exchange for the monopoly over all trade to the South Sea (Malkiel, 2016), successfully drove people to invest in its stock. The excitement wouldn’t have been so extreme had it not been for the rise of the French Mississippi Company stock that triggered the jingoism of the British. After the price climbed to £1000 per share in August 1720, a widespread sell-off kicked in and thus crashed down the once highly promising money-maker South Sea Company.

Turning to the 20th century, another powerful stock market crash took place, resulting in the never-to-be-forgotten Great Depression. Within only eighteen months from March 1928 to September 1929, the US stock market had increased almost as much as it had been throughout the whole five-year period before that. The amount of money that was borrowed to buy stocks also went up by nine times larger, from $1 billion in 1921 to $9 billion in 1929 (Malkiel, 2016). Later came the “Black Thursday” October 24 and the “Black Tuesday” October 29 that ignited the chain of panic selling, resulting in the leap of the unemployment rate at 25 percent and the ‘evaporation’ of more than 5,000 banks. Many other markets worldwide also corrupted, yet the crisis was still on its way.

Leaving the Western side, the Eastern world also had an infamous crash in the 1980s, which was fuelled by the country’s own monetary policy and affected both real estate and the stock market – Japan’s Bubble Economy. After the Plaza Accord being signed in 1985, the overseas investments became cheaper for Japanese companies and thus incentivized Bank of Japan to lower its interest rates. Both institutions and individuals increased their purchases of domestic stocks as well as urban land, which, as a consequence, pushed the stock index to 1.5 times larger than that of the US and the price of selling the Imperial Palace to enough for buying the whole California (Malkiel, 2016). By the end of 1989, the monetary policy was tightened, causing the bubble to pop and turning three-decade “Economic Miracle” to “Lost Decades” (Colombo, 2012).

Although our daily life has become a lot easier and more convenient since the revolution of the technology, especially the appearance of the Internet, what the Internet companies brought to investors on the stock markets around the beginning of the 21st century was a different story. In 1994 when the Internet was made available to public, the number of its users kept on increasing and attracted the huge temptation towards this potential market, followed by the wave of newly established online companies and their IPOs. NASDAQ skyrocketed just in couple of years, reached to 5000 points in stock index at its peak with the price-earnings ratio of above 100. At the time, tech companies were said to be bid up to ridiculous P/E multiples, and becoming a millionaire was just a matter of 60 seconds in Silicon Valley. Not so long after that did the investors start to understand that there had been a speculative bubble going on, NASDAQ Composite lost 78% of its value falling from 5046.86 to 1114.11 (Beattie), bringing the Dot-com Bubble to an end.

Above is a brief overview of some well-known booms and busts on the markets throughout decades. From these, we can probably have a general idea that a bubble is probably to happen when market participants get overly enthusiastic about an asset and this enthusiasm spreads at such a speed of light that pushing the asset’s price to way above where it should be. In the next chapter, we will get to know more in-depth information on the approach of Behavioural economists to asset bubbles and what the reasons for the occurrence of one are likely to be.

What is an asset bubble?

Notwithstanding that each individual may have his/her own belief of what a so-called “asset bubble” is, a common definition usually used for this term is that it’s a situation where an asset is traded at a highly overvalued price compared to its fundamental value. When referring Eugene Fama’s work on “efficient market hypothesis”, Richard Thaler (2015) also suggested that there would never be bubbles if the prices were right. However, this seems a little indistinct as we probably couldn’t observe the intrinsic value of an asset, nor say what the correct price for it is supposed to be.

Going out of the mainstream’s tune, behavioural economists define a bubble grounding on the findings of the psychology and reactions of market participants. In the third edition of the book Irrational Exuberance, Shiller expressed his idea of a speculative bubble as followed:

“A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, and, in the process, amplifies stories that might justify the price increase and brings in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.

This definition is, indeed, giving a clearer and more detailed view on where the boom might be rooting from. It points out the involvement of the information on price trend, the behaviours of market participants, and their speedy spread among people in the process of lifting the price. We can also see here some sort of a feedback loop, where at first the price is pushed with the contribution of the news and the epidemic nature, after that this price increase draws in even more demand from investors, then leading to even further price rise. This vicious circle keeps on going and, as a result, the price goes up to an unpredicted extraordinary level.

Yet, people’s excitement can’t last forever, and neither does the phenomenal price. A crash usually appears when investors, by some means, learn that the asset they have been chasing after is not going to pay them any more substantial fortune than what they are giving for it. Keeping this in mind, we, however, hereafter rather than looking into both reasons on how a bubble comes and goes, will only focus on whether the renowned explanations for a bubble’s roots of the behavioural economists are actually sensible.

Several behavioural factors leading to a speculative bubble

The Efficient Market Hypothesis, as once mentioned previously, proposes that all the public information is accurately reflected in market prices, thus assets are always traded at their fair value, there will be no chance to make a profit out of arbitraging, and it will be unlikely for bubbles to happen (Shiller, 2014). This seems pretty convincing and, in fact, many economists supported and provided empirical evidence in favour of it. However, the hypothesis and most of the asset pricing models that were used appear to be neglecting the fact that people don’t always behave as in rational expectations. The discussion of the famous British economist John M. Keynes on financial markets, as cited by Thaler in his book Misbehaving: The Making of Behavioural Economics, also suggested that human emotions played an important role in individual decision-making, including investment decisions. Hence, whatever making their behaviours departed from the “expected rational behaviours” of the models are likely to break the efficient market and, as the consequence, push the prices away from their current “fair value”.

Shiller (2015) divided what he thought to have the influence on the price increases into three categories: structural factors, cultural factors, and psychological factors, with the general theme behind them circles around the occurring of Ponzi processes. At the beginning, cultural factors such as the news media or new era economic thinking, and psychological factors like herd behaviour or epidemics, alongside with many other factors have built up a list of precipitating factors, possibly explain the initial movement of prices. These factors then get amplified by investor confidence, expectations, and demand, which makes the feedback cycle run repeatedly and, consequently, blows up the prices to an extreme level. To understand more about this idea, let us have a quick walk through Shiller’s explanation for the Millennium Boom of the 1980s – 2000s.

According to his writing, the attention of public to stock markets, especially Internet companies’ stocks, apart from being drawn by the appearance of the Internet itself, was propelled by eleven other factors which specially included the growth of media reporting on stocks, the increase of defined contribution pension plans, and the extension of the trading volume. The release of the Cable News Network (CNN) in 1980 had gradually developed the habit of watching the news on the television network in the community, paving the way for the arrival of CNN Financial Network and Bloomberg Television in the later years. As the habit still stuck to them, the viewers then got to receive more information about stock markets as they watched TV. This captured their interest in investing in the field and thereby led to greater demand for stocks. At about the same time, the creation of the first 401(k) plan forced people to learn about stocks and their advantages against bonds or other types of investments. Benartzi and Thaler study in 2001 concerning this plan also found that people tended to allocate their savings into each option of the available set equally, regardless of the differences in the percentage of stocks and bonds consisted in those options. With this being acknowledged, we can presume that the employers could possibly categorize the investment options in the way that would encourage the demand for stocks. Another noteworthy factor from the 80s to 90s was the jump in the turnover rate of stock exchange markets at an exceptional level. Partially contributed to the increase of more than 130% in NASDAQ turnover rate were the rise of discount brokers and mutual funds, which made investing cheaper and more accessible for individuals. Changes in technology alongside also allowed the markets to trade all day long at a lower cost. The easier it got to access to stocks, the more attention investors paid to this fertile market.

Each of and all the above-mentioned factors, either singly or simultaneously, had made an impact to precipitate the stock prices at the time. As these factors made public become interested in investment, the psychological factors of people’s minds and actions started to kick in and boost the initial effect up to a larger extent.

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