Can Behavioural Finance Explain Asset Bubbles?

Can Behavioural Finance Explain Asset Bubbles?

At a time when many major stock indices around the world are trading well above there historical averages on a Price to Earnings basis talk of a potential bubble is never far away. Whilst more traditional economic thought often points to inexpensive and easy access to credit as the principle cause of asset bubbles the relatively new field of behavioural finance provides another perspective on this phenomenon.

From a behavioural finance point of view asset bubbles are a study in two things very closely linked to financial markets – fear and greed. Naturally then asset bubbles begin with greed. According to research done by Jean-Paul Rodrigues we usually see the first signs of greed after the smart money has correctly identified a potential upward trend and after the institutional investors have started pushing prices above there long run average. The finance media gets a hold of the story and is quick to explain the surge in prices via the creation of some “new economic value”. This type of publicity quickly produces buyers motivated by a fear of missing out (FOMO) who in turn further drive prices even higher. These FOMO buyers quickly shape market sentiment which pushes asset prices significantly above their historical normals. The media and those who have already invested however are quick to proclaim this new price level as the “new normal” which leads to another wave of FOMO buyers joining the herd. This herd mentality then intensifies and an overwhelming euphoria takes over as investors quickly cast aside the fundamentals of their investment and see only the incredible gains they have made.  This ultimately culminates in the final stage of the bubble where investors totally disregard the fundamentals of the particular asset and buy simply on the basis that past returns have been substantial so future returns will be equally as stunning.  Inevitably though there is a trigger which ends this period of greed and sees prices come off their previous highs. This initial price decline often sends investor’s particularly those who entered into positions at the peak into a period of denial.  These investors who are still in denial often get themselves caught in a bull trap as they enter into new position believing the asset can still run even higher.  This actually often provides short term price support but ultimately it proves futile as those who entered at the peak sell off there loosing positions which drives further price decreases and further selling. Fear sets in shortly after this and asset prices fall even more dramatically than they rose, often to levels substantially below even the most conservative estimates of intrinsic value.

Whilst it’s important to understand how behavioural finance believes asset bubbles  work perhaps the most important lesson from behavioural finance is that investors need to honestly and thoughtfully examine their own decision making process.  Investors should look to the insights provided by behavioural finance as a means of scrutinising their own decision making to ensure even during the mania of a bubble that there decisions remain rational and thought out....


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