Why do we get bubbles in markets?

Sunday, 3 October 2010 22:29 -     - {{hitsCtrl.values.hits}}

By Kim Stephenson

Business Psychology Consultantand Financial Advisor

Maybe in a few thousand years we might be totally rational beings, but we aren’t now!  To try to stop or even mitigate the effects of market bubbles, we must have regulation that understands people as unique individuals who don’t always act consistently – or even “predictably irrationally” all the time.  

According to economic theory bubbles can’t happen, markets are self limiting.  As more people buy a product the remaining market diminishes.  Whether the market is housing, shares or trainers, at some point everybody who wants it has bought it and the market saturates.  But this ignores the way people are.  

First, in reality you get positive feedback.  It seems everybody has a particular phone, share or holiday property.  People want it because other people have it, and the more people have it, the more you feel left out if you don’t have it too.  It isn’t self-limiting, it is self sustaining.

Second, there is a saying that you are rich if you earn $100 a year more than your wife’s sister’s husband.  Most people judge their personal wealth not by whether it provides what they want in life, but by whether they have more than their brother-in-law or peer group.  If other people have it, you want it too as proof that you are as good as they are.

Third, for most of human history we were tribal.  Our tribe was safe, they looked like us, spoke like us, saw the world like us.  Outside our tribe we wouldn’t survive alone and other tribes were dangerous.  That’s the basis of prejudice and the habit of hiring people who are family, or who are at least “like us” in attitude, clothing styles, politics etc.  Tony Dye, the fund manager was alone, he predicted a market crash in the 1990s, everybody laughed at him, journalists, other fund managers, clients; finally, even his own firm.  He left the job and a few weeks later the crash he’d predicted came.  He was right, but he was on his own and he’d been ridiculed and lost his job.  Nobody else, even those who lost millions from their funds, lost their jobs – they were wrong, but they were in a tribe and were safe.

Fourth, we’re loss averse.  There’s good evidence that most people will take risks to avoid a loss, but avoid risks and take immediate gains.  This is apparent in the number of people who sell rising shares and hang on to losing ones, both of which are demonstrably poor strategies. It also shows in the “framing effect”, people make different decision on exactly the same information if one option is “framed” as a chance of profit and the other described as a chance of loss.  When a bubble starts, it seems more of a risk to join.  But as it goes on, everybody (we think) is in.  We might resist, but eventually it seems that it is a bigger risk to be outside – everybody else is in the tribe, they are all making money, all the smart people are there.  So we join, because we are human.

It puzzles a lot of people that we also react in exactly the opposite way sometimes.  We “anchor”, fix on a value and won’t move.  So we think our house is worth a particular figure.  The house is worth what somebody will pay for it, but that isn’t its value to us.  Similarly, most of us show a degree of “endowment effect”, if you add the word “my” to any object you increase its value in your own eyes.  And we are usually overconfident that we understand things better than others.  In fact feeling inadequate most of the time can be a sign of depression.  All of these would seem to suggest we would have our own values, wouldn’t take other people’s opinions into account, and would reject “experts” views. And this confuses naive attempts to “allow for human nature”.

 But these apparent contradictions occur because each person is unique, and people’s behaviour in groups is a complicated mix of their individual views, the effects of the general view and particularly the environment. That is the reason that “decision architecture”, shaping the environment in which decisions are made, has become a big enough issue for the UK Government to hire advisors about it.  Of course, they have forgotten that exactly the same principles have long been used in shops.  Supermarkets are laid out based on knowledge of how people make buying decisions, both individual and en masse, and the specific placing of items on shelves is a form of decision architecture that pre-dates modern “expert thought” by at least half a century.

Regulation in financial services has focussed on the mechanics of how bubbles happen. But why they happen is more important.   The current attitude is to ignore human nature, with a small movement to have regulation that embraces humanity by suggesting that people should be more rational.  That movement also assumes that “the public” are irrational, but “professionals” are somehow much better.  They are all human.  With more space I could explain why, when one in a thousand funds should beat the relevant market index by pure chance every year for 10 years, none of more than 6,000 funds in the UK do, although the apparently inept fund managers are still confident that they are “special”.  Or why the most recent bubble, the sub-prime market in the US was developed, blown up and popped by “expert” professional investors, not the public.  

People won’t be rational – not in a way that would make economic theory work and bubbles impossible, and it doesn’t matter whether they are professional investors, the public or psychologists.  If we were not human, we might be totally logical about every decision.   We are the way we are today because of millions of years of evolution made the combination of automatic systems, subconscious cues and conscious thought based on subconscious feelings, emotions and cognitions work.  It kept our distant ancestors alive long enough to produce our nearer ancestors and eventually us.  

The people who took too long to join the tribe, to work out their status relative to others, to realise that losses are more serious than gains in a hunter-gatherer environment, died without many offspring.  Maybe, in a few 1000 years we might be totally rational beings.  But we aren’t now.  Bubbles are possible, they will happen and to try to stop them or mitigate their effects we have to have regulation that understands how people are and that they are unique individuals who don’t always act consistently – they aren’t even “predictably irrational” all the time.  

(Kim Stephenson CPsychol, ACII, DipPFS is an unique combination of chartered occupational psychologist and qualified financial advisor, working in the UK.  Kim, author of the finance book Taming the Pound (to be published in 2011), has just launched the financial psychology website of the same name, Tamingthepound.com. He contributes regularly to media on psychological issues surrounding money, and has been featured in The Guardian, Citywire, BBC radio and Sense, the Royal Bank of Scotland customer magazine.  )