A Better Theory To Explain Financial Bubbles

Ted

FYI: What causes asset bubbles? This question is the great white whale of finance theory. We know that asset prices are given to spectacular rises and falls over short periods of time. Answering this question is hugely important, not just for people’s pensions and retirement, but for the whole economy, since crashes in asset prices can leave growth in the doldrums for years.
Regards,
Ted
https://www.bloomberg.com/view/articles/2016-12-08/a-better-theory-to-explain-financial-bubbles

LewisBraham

This part is hilarious:

"One possibility is that investors simply make mistakes when projecting future asset returns. If stocks have had an outstanding run for the past five years, or if earnings growth seems to have shifted to a faster trend, people might decide that this is the new normal, and pay prices that later turn out to be ludicrous.
In much of the economics profession, it’s still almost taboo to even consider this kind of human mistake. Most econ models are still based on rational expectations, the idea that people don’t systematically make errors when forecasting the future."

Can someone please finally push the stake into the heart of "Homo Economicus?" Human beings haven't been considered "rational" since Freud, yet economics seems to be about one hundred years behind the times, believing that investors make rational decisions and projections and that the market is thus efficient.

JohnChisum

Who should make those decisions then?

MJG

Hi LewisBraham,

Wow, you are one tough critic. I did not find the passage you quoted or any other section of the referenced article "humorous", I liked the article; it is serious stuff written by a respected and serious financial writer.

The Homo Economicus model is simply a model that was mostly favored in the 1960s and 1970s. The key point is that it is only a model, and models are imperfect approximations of complex happenings. And just.about every scientist expects models to change as more data and a better understanding develop over time. That's happening now. For example, Behavioral economic modeling is causing adjustments to the rational man assumptions integrated into earlier models.

I suspect most MFOers would consider themselves rational investors who accumulate data and make decisions based on a careful assessment of that data. Are errors made? Most assuredly the answer is Yes. But starting with a basic rational investor model is likely a good point of departure since it is likely to generate a respectable base rate.

I consider myself a member of the Homo Economicus clan. Do I violate its assumptions and rules? On rare occasions I do. I often pay dearly for those high fliers. But I also use the extrapolate expectations data group that was also favorably highlighted in the referenced piece. Like any method, this too can do harm since turning points are not identified. Trends don't persist forever.

There are no perfect models in investing or medicine or even in physics. Approximations abound. That's the real world.

I like most of your submittals, but this one is too highly nuanced.

Best Wishes.

LewisBraham

@John, There are many ways of addressing the problem of irrational human behavior with varying degrees of success for investors: a quantitative smart beta approach that takes humanity largely out of the equation employing various factors; a pure index approach that wins not because markets are efficient but because of low costs and comprehensiveness of exposure--what Bogle called the Cost Matters Hypothesis; a combination quant-active approach where the numbers from the machine act as a check on irrationality while human judgment acts as a check on overly simplistic numbers; a team based active approach in which each manager acts as a check on the other so if one is behaving irrationally the others tell him/her so. Of course, each has its flaws, the last one for instance being that a team could be subject to group think. One could also insist that any serious investor take classes in behavioral finance so they could attempt to self-correct. Nothing is the perfect solution, but the idea that markets are efficient and rationally governed should be long dead and buried by now.

@MJG Being good at rationalizing one's behavior and being rational are two different things.

From Ritholtz:

<a href="https://www.bloomberg.com/view/articles/2016-12-05/a-portrait-of-two-men-who-changed-how-we-think"

"(Michael) Lewis almost casually takes the reader through decades of psychological innovation, culminating in Tversky and Kahneman's slow demolition of the concept of homo economicus -- the underlying assumption of the economics profession that people are rational, self-interested optimizers with perfect judgment. All of the biases and cognitive failings that people exhibit when making decisions are laid bare here. We watch as it becomes clear that errors in human judgment are not merely predictable, but systematic."

Crash

"...One could also insist that any serious investor take classes in behavioral finance so they could attempt to self-correct...." I bet it's safe to say that those of us in here (for example) are serious about wanting to learn, self-correct, make informed decisions, and all of that. It is a goddam crime that high schoolers and college students are not required to learn at least BASIC STUFF about the sort of information which can serve to guide one's use of money, and lead to successful investing. What I learned about it all was done on my own, plus taking away lessons from this very discussion board. And I never started to make any REAL money (i.e., a basic salary with benefits) until age 38.

JohnChisum

Irrational human behavior as Lewis refers to is just one side of the coin. The markets themselves exhibit a behavior of their own. Rational and irrational. The markets have a tendency to make fools out of everyone that participates.

No system is capable of fixing that.