The psychology of market bubbles

[stockGURU]

A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation.

Behavioral finance theory attributes stock market bubbles to cognitive biases that lead to groupthink and herd behavior. Bubbles occur not only in real-world markets, with their inherent uncertainty and noise, but also in highly predictable experimental markets. In the laboratory, uncertainty is eliminated and calculating the expected returns should be a simple mathematical exercise, because participants are endowed with assets that are defined to have a finite lifespan and a known probability distribution of dividends. Other theoretical explanations of stock market bubbles have suggested that they are rational, intrinsic, and contagious.

http://en.wikipedia.org/wiki/Stock_market_bubble

They say that those who do not learn from history are doomed to repeat it. Well, it seems that there are some things that the human race never learns from, and market bubbles appear to be one of those things.

From "tulip mania" in 17th century Holland to the recent resources bubble of 2005-2007 and the housing bubble in the US, market bubbles have repeated regularly throughout history and it seems that even though we are aware of them and the their inevitable disastrous end, to this day while they are happening many people don't seem to recognise the bubble as it is inflating and the end of any financial bubble never fails to bring down a huge amount of people with it.

I'm fascinated by the psychology of market bubbles and thought that others might have an opinion on the topic. Greed, fear, herd mentality: it's a fascinating study of human behaviour and one that, if studied in enough detail, can be profited from.

A lot of money can be made by getting into a bubble near the beginning and riding it all the way to the top, but how do we know when to get out? Just as importantly, how do we know when a bubble is starting? Are there signs to look for?

The charts of market bubbles take on a very similar pattern and I have attached a few to this post to illustrate it.

Chart #1: Tulip mania in Holland 1636-37
Chart #2: Nikkei 225 bubble during the 1980's.
Chart #3: NASDAQ "Dot com" bubble of the late 1990's.

What can we learn from the predictability of market bubbles, and how can we profit from them?

Thoughts?

 

[Wysiwyg]

I'm fascinated by the psychology of market bubbles and thought that others might have an opinion on the topic. Greed, fear, herd mentality: it's a fascinating study of human behaviour and one that, if studied in enough detail, can be profited from.

'Strong' demand does not last forever.

The greater fool theory suggests that no matter what price an investor pays for a share, someone (the greater fool), with less education and less understanding of the market, will buy it at a higher price. Eventually the price rises to a figure when the greatest fool buys because s/he cannot find anyone to buy it at a higher price. When the greatest fool buys the market has reached its peak and is set for a correction.

How do you know if you are the "greatest fool"? Well only history reveals that.

 

[RamonR]

How do we know when a bubble is forming?

I have always been suck into one in the past after hearing on the news night after night for about six months or so how much money people are making in the market.

 

[OzWaveGuy]

There was an interesting doco on SBS last night - How To Survive A Disaster

A team of leading experts put together the ultimate guide to disaster survival. Through controversial experiments, computer simulations and analysis of hundreds of survivor testimonies from plane crashes to ferry disasters and even 9/11, they reveal what happens in the mind in the moment of crisis and how the human brain can be programmed for survival.​

I didn't watch the entire show, but there was an interesting experiment demonstrating herd behavior at work during disasters....a quick summary:

With one person in a room filling out a form, smoke was pumped under a door close by. The subject quickly left to alert someone of the smoke.
Again the experiment was repeated this time with a group. However, the entire group - except one person, was secretly given instructions to ignore the smoke. As the smoke filled the room, the individual who was unaware they were participating in an experiment did not seek help or even speak out, but instead stayed quiet (but very anxious) until someone else from the group acted (when the smoke was considerably thick).​

It struck me as being very similar to the markets - when optimism is at an extreme, very few will smell the smoke and get out on the high. Even when a downtrend is established - many will still stay in (hold for the long term), ignoring the smoke and flames, perhaps to exit near the bottom when pessimism is at an extreme.