Science unveils hidden drivers of stock bubbles and crashes

AFP ^ | Sep 18, 2008 | Marlowe Hood and Richard Ingham

[decimon]

PARIS (AFP) - Many economists believe that investors make decisions rationally, weighing up corporate data and other pricing signals to evaluate gain or risk before buying or selling stocks.

But this keystone belief in how markets function is now under mounting attack after this month's global stocks crash, the latest in a string of financial shocks over the past two decades.

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During the dot-com boom, he says, he was stunned to see male traders "displaying classic symptoms of mania," with symptoms of omnipotence, raging thoughts and diminished need for sleep.

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[decimon]

Homo Economus, RIP.

[abb]

From the dawn of mankind, emotion has always had a much greater impact on money and wealth than has logic. Fear and greed. Always has, always will.

[CatoRenasci]

Nah, this is old news.

[The Great RJ]

Part of the mania is driven by media who calls every financial blip a crisis and characterizes a normal downturn in the business cycle another Great Depression.

[decimon]

Nah, this is old news.

The rational actor (homo economus) has been much a part of free-market economics. I agree that individuals make better decisions for themselves than any imposed upon them by any collective or cadre of experts but the idea that people will act rationally is an iffy idea. People tend to join ad hoc collectives (running with the herd) when there is a dream to chase.

[tcostell]

The truth is actually somewhere in between. There is a component of behavior finance (related to behavioral economics) called an "information cascade" which accurately depicts the cause and effect of the 'boom-bust' cycle. It also points to the only way to prevent events like this in the future.

I've spent most of the last 10 years studying this very issues, and this is a high level essay on how to prevent them in the future.

The upshot is that people make decisions differently when in a group than they do when they're acting on their own. Psychologists who try to atrtribute this to individual brain chemistry tell only part of the story.

[Raycpa]

I don’t recall that the premise of the free market is based on rational decisions. It is based on people following their best interest which includes greed.

The sum total of all of these rational and irrational decisions arrives at logical conclusions for allocating resources. Yes, even if the actors are manics or depressives.

What the market needs more than anything is accurate and relevant information. The more accurate and relevant the information, the less necessary it is to act on emotion.

[tcostell]

While I agree with you in principle, I'd like to warn you about your casual use of language. In point of fact, the "accuracy" and "relevancy" of the information is all determined by the economic participant as well. That may seem like semantics at first but if you think about it a bit, it's clear that it's not.

Also, more information will very often lead to noise rather than signal. Even that term is a bit stretched as you use it but I confess that it's sometimes hard to find a substitute.

[50sDad]

Again, blame the man.

[decimon]

I don’t recall that the premise of the free market is based on rational decisions.

Moot point as that is not what I said.

[roaddog727]

About 20 years ago, I was working on a PhD. on just this sort of thing. Regretfully I never got to complete it (Ran out of funding). But essentially, what we are now seeing is Chaos theory in action. (See James Gleick’s book “Chaos” and review the works of Feigenbaum and Mandelbrot).

Systems going from order to disorder in an orderly fashion - driven my socioeconomic factors. the Socioeconomic factors - uncertainty - drive the mob mentality, creating the disequilibrium in the system causing these Chaotic events.

Once the socio-enconomic factor stimulus is removed or assuaged, the system comes back to it's original equilibrium state, or to a new (high or lower, depending...) state.

[decimon]

Thanks for the link.

A couple of quibbles:

The overvaluation of real property extends beyond the US.

You say: “Financial innovation which creates complex instruments which only a few people have the knowledge to accurately value...” I doubt that anyone, including the creators, can evaluate arcane financial instruments for more than a week, if at all.

[tcostell]

I doubt that anyone, including the creators, can evaluate arcane financial instruments for more than a week, if at all.

It's cerainly fine with me for you to have your doubts, but as a guy who has done that for a living for nearly 20 years I hope you will allow me and the other people who know all the details to continue to have confidence that 2+2 = 4.

This was never a valuation problem, it was a markets problem. The two are not the same thing.

[tcostell]

Personally, I'm convinced that all those fractal structures are descriptive not causative. Everyone I know (including me) bought that book and the Mandelbrot book, and modeled all the functions, and it never amounted to anything that could be used predictively.

I don't mean that it isn't sound research for it's own right, only that the scope needs to be defined.

[roaddog727]

“Personally, I'm convinced that all those fractal structures are descriptive not causative.”

Precisely.

Descriptive and not causative. The causative factors are the socioeconomic “perceptions” of the people driving the system.

[decimon]

From Wikipedia: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one!” Charles Mackay

Maybe Mackay gave us all we need to know.

[decimon]

It's cerainly fine with me for you to have your doubts, but as a guy who has done that for a living for nearly 20 years I hope you will allow me and the other people who know all the details to continue to have confidence that 2+2 = 4.

Well, 2+2=4 is not a complex financial instrument with multiple variables and dependencies.

[CatoRenasci]

Interesting essay. The difficulty in discussing this in threads and on the net is that there is both a large traditional literature on this stuff (think Mackay's Extraordinary Popular Delusions and the Madness of Crowds and Ortega y Gasset's The Revolt of the Masses as starting points) and a modern, mathematically arcane, literature that deals with the notions of chaos and things like the 'rational investor' -- which is a popular misunderstanding of what even classical microeconomics (let alone neoclassical microeconomics) teaches. As you say, it's not so simple if you want to be accurate.

I noticed your reference to Amaranth on the blog essay - a friend of mine was an economist with them.... This stuff isn't really my area, my graduate work in mathematical economics was in general equilibrium theory and social choice theory, but it's interesting. I'd appreciate further cites to what you this is the relevant recent literature.

[Glenn]

"displaying classic symptoms of mania," with symptoms of omnipotence, raging thoughts and diminished need for sleep.

This reminds me of something.

Hang on.

It'll come to me.

Unh. Unh.

That's it!

The World Poker Tour!

[roaddog727]

Indeed.