Monday, April 20, 2009

Why Do We Fall for Bubbles?

One feature about unsustainable asset bubbles (boom and busts) is the regularity with which they occur. Housing boom and busts are common in UK. Often we see a mania for a certain type of investment only for it to implode - e.g. from Tulip mania in the 16th Century to the 20th Century dot com bubble, it seems consumer rationality often falls by the wayside at the prospect of a quick buck.

Why is It Difficult To Spot Asset Bubbles?

We don't like Bad News.

Perhaps human nature is inherently optimistic. Or maybe it is just greed - people would rather hear forecasts of rising wealth rather than grim warnings.

The Herding Effect.

Psychologists have often noted a herding effect. The strongly held belief that the majority must be right. If market sentiment is bullish on a commodity - who am I to go against all those specialists?

Bubbles create their own momentum.

Rising asset prices changes peoples behaviour. When house prices are rising mortgage companies have more incentive to sell mortgages with small deposits. Banks feel more optimistic so become more willing to lend. Rising asset prices encourages speculators into the market creating a self fulfilling prophecy of rising prices.

Short Termism

Many people in the chain are not thinking about long term sustainability. Mortgage salesmen get commission for selling mortgages and they are more concerned with short term performance related pay rather than long term sustainability of the mortgage. Bankers often get commission for making short term profit, but don't lose money if the market goes down. A bubble commodity gives chance of huge bonuses. But, if bubble collapses, bankers don't have to pay it back. It becomes a one way bet. You benefit from bubble - and someone else (i.e. taxpayer) loses when the bubble bursts

It's Different this Time.

When price to earning ratios skyrocketed for internet stock, warning bells should have started to ring. It looked like a classic stock bubble. But, people believed or wanted to believe that the internet meant different rules applied.

When house prices rose in UK 1997-2006, many pointed to low interest rates, shortage of supply, demographic factors to suggest house price to income ratios could rise above long term averages.

Fundamental Gullibility.

People just like the prospect of making a quick buck. And bubbles can be a way to do it. People just think they will be able to sell at the right time.

Lack of Information.

When many ordinary people buy a house, they don't think in terms of long run house price to income ratios. They want to buy a house to live in it. If this means getting a mortgage 5 times salary then this is what they will have to do. They aren't buying to benefit from rising house prices, they just want to get on property ladder.

It's Not Difficult to Spot.

People do spot credit bubbles, housing bubbles, it's just people don't give negative warnings much attention.

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