13.1 Theories of Asset Price Bubbles

Asset price bubbles occur when market prices far exceed an asset's true value. They're driven by factors like low interest rates, easy credit, and investor overconfidence. Bubbles can wreak havoc on economies when they burst, causing financial instability and recessions.

Several theories explain bubble formation. The greater fool theory suggests investors buy overvalued assets hoping to sell to a "greater fool." Herding behavior and cognitive biases like overconfidence also play roles. Market inefficiencies and media hype can further fuel bubble growth.

Asset Price Bubbles

Definition and Characteristics

Top images from around the web for Definition and Characteristics

• 

  Some Important Characteristics of Asset Bubbles and Financial Crises View original

  Is this image relevant?

• 

  Some Important Characteristics of Asset Bubbles and Financial Crises View original

  Is this image relevant?

• 

  Monetary Policy and Economic Outcomes | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Some Important Characteristics of Asset Bubbles and Financial Crises View original

  Is this image relevant?

• 

  Some Important Characteristics of Asset Bubbles and Financial Crises View original

  Is this image relevant?

1 of 3

Top images from around the web for Definition and Characteristics

• 

  Some Important Characteristics of Asset Bubbles and Financial Crises View original

  Is this image relevant?

• 

  Some Important Characteristics of Asset Bubbles and Financial Crises View original

  Is this image relevant?

• 

  Monetary Policy and Economic Outcomes | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Some Important Characteristics of Asset Bubbles and Financial Crises View original

  Is this image relevant?

• 

  Some Important Characteristics of Asset Bubbles and Financial Crises View original

  Is this image relevant?

1 of 3

• An asset price bubble occurs when the market price of an asset significantly exceeds its intrinsic value or fundamental value for a sustained period
• Key characteristics of asset price bubbles include:
  1. Rapid increase in asset prices
  2. Widespread speculation and excessive risk-taking
  3. Belief that prices will continue to rise
  4. Eventual collapse of prices
• Asset price bubbles can occur in various markets (stocks, real estate, commodities, cryptocurrencies)
• The formation and growth of asset price bubbles are often driven by factors such as:
  1. Low interest rates
  2. Easy credit availability
  3. Irrational exuberance among investors
• The bursting of asset price bubbles can have significant economic consequences:
  1. Financial instability
  2. Wealth destruction
  3. Recession

Economic Consequences

• The bursting of asset price bubbles can lead to financial instability as the value of assets plummets and investors suffer significant losses
• Wealth destruction occurs when the value of assets held by individuals and institutions declines sharply, reducing their net worth and purchasing power
• Asset price bubbles can contribute to recessions by triggering a decline in consumer spending, investment, and overall economic activity
• Examples of economic consequences of asset price bubbles include:
  1. The 2008 global financial crisis triggered by the bursting of the US housing bubble
  2. The dot-com bubble burst in 2000, leading to a recession in the technology sector

Theories of Bubble Formation

Greater Fool Theory and Extrapolation Theory

• The greater fool theory suggests that investors buy overvalued assets believing they can sell them at a higher price to a "greater fool," leading to the growth of bubbles
  • Investors knowingly purchase overvalued assets with the expectation of finding someone willing to pay an even higher price
  • This theory assumes that there will always be a "greater fool" to buy the asset at an inflated price
• The extrapolation theory proposes that investors extrapolate recent price trends into the future, expecting prices to continue rising, fueling bubble formation
  • Investors assume that the recent price appreciation will persist indefinitely, leading them to buy assets at increasingly higher prices
  • This theory suggests that investors tend to give more weight to recent price movements and disregard long-term fundamentals

Herding Behavior and Rational Bubble Theory

• The herding behavior theory explains how investors tend to follow the crowd and mimic the actions of others, contributing to the expansion of bubbles
  • Investors base their decisions on the actions of the majority rather than their own analysis and judgment
  • This theory highlights the psychological tendency of individuals to conform to the behavior of the group, even if it goes against their own beliefs
• The rational bubble theory argues that bubbles can form even when investors are rational, as they believe they can sell the asset at a higher price before the bubble bursts
  • Investors are aware of the overvaluation but believe they can time the market and exit before the bubble collapses
  • This theory suggests that bubbles can persist as long as investors believe they can find a buyer willing to pay a higher price

Credit Expansion Theory

• The credit expansion theory links bubble formation to the expansion of credit and leverage, which enables investors to take on more risk and drive up asset prices
  • Low interest rates and easy access to credit encourage investors to borrow money to invest in assets, fueling demand and price increases
  • Leverage amplifies the potential gains and losses, making the bubble more fragile and prone to collapse
• Examples of credit expansion contributing to bubble formation include:
  1. The subprime mortgage lending boom prior to the 2008 financial crisis
  2. The margin lending practices during the 1920s stock market bubble

Psychology of Bubble Formation

Cognitive Biases

• Overconfidence bias leads investors to overestimate their ability to predict market trends and make profitable investments, contributing to excessive risk-taking
  • Investors believe they have superior knowledge or skills compared to others, leading them to make bold and risky investment decisions
  • This bias can cause investors to ignore warning signs and continue investing even when the market is overheated
• Confirmation bias causes investors to seek information that confirms their existing beliefs and ignore contradictory evidence, reinforcing their conviction in the bubble
  • Investors tend to focus on information that supports their investment decisions and dismiss data that challenges their views
  • This bias can lead to a false sense of confidence and a reluctance to reassess investment strategies
• Anchoring bias causes investors to rely too heavily on an initial piece of information, such as the recent price trend, when making investment decisions
  • Investors may anchor their expectations to a specific price level or trend, disregarding other relevant factors
  • This bias can cause investors to maintain their bullish outlook even when market conditions change

Emotional Factors

• Fear of missing out (FOMO) drives investors to enter the market during a bubble, as they believe they will miss out on potential profits if they don't participate
  • Investors feel pressure to invest in the booming asset to avoid regret and the perception of lost opportunities
  • FOMO can lead to impulsive and irrational investment decisions, fueling the growth of the bubble
• Herd mentality or bandwagon effect occurs when investors follow the actions of the majority, leading to a self-reinforcing cycle of buying and price increases
  • Investors base their decisions on the behavior of others rather than their own analysis, creating a feedback loop that amplifies the bubble
  • The herd mentality can create a sense of safety and validation, as investors believe that the crowd must be right
• Examples of emotional factors contributing to bubble formation include:
  1. The fear of missing out on the dot-com boom in the late 1990s
  2. The herd behavior during the Bitcoin and cryptocurrency bubble in 2017

Availability Bias and Media Influence

• Availability bias leads investors to overweight the importance of readily available information, such as media coverage of the booming asset, in their decision-making process
  • Investors are more likely to remember and consider information that is easily accessible and frequently discussed
  • Media hype and sensationalized reporting can fuel investor enthusiasm and create a sense of urgency to invest
• Media coverage and public attention can amplify the growth of asset price bubbles by:
  1. Spreading optimistic narratives and success stories
  2. Attracting more investors to the market
  3. Reinforcing the belief that prices will continue to rise
• Examples of media influence on bubble formation include:
  1. The media frenzy surrounding the dot-com boom in the late 1990s
  2. The extensive coverage of the housing market boom prior to the 2008 financial crisis

Market Inefficiencies and Bubbles

Limits to Arbitrage and Short-Selling Restrictions

• Market inefficiencies, such as limits to arbitrage and short-selling restrictions, can allow asset price bubbles to persist and grow
  • Limits to arbitrage refer to the constraints that prevent investors from exploiting mispricing and bringing prices back to fundamental values
  • Short-selling restrictions make it difficult for investors to bet against overvalued assets, limiting the ability to counteract the bubble
• These inefficiencies can hinder the self-correcting mechanism of the market and allow bubbles to expand further
• Examples of limits to arbitrage and short-selling restrictions include:
  1. The difficulty of shorting real estate during the housing bubble
  2. The temporary ban on short-selling financial stocks during the 2008 crisis

Information Asymmetry and Market Manipulation

• Information asymmetry occurs when some market participants have access to more or better information than others, leading to mispricing of assets
  • Insiders or well-informed investors may take advantage of their knowledge to profit from the bubble while others remain unaware
  • This asymmetry can create an uneven playing field and contribute to the growth of the bubble
• Insider trading and market manipulation can exacerbate information asymmetry and contribute to the formation of bubbles
  • Insiders may engage in fraudulent activities or spread false information to drive up prices and benefit from the bubble
  • Market manipulation techniques, such as pump-and-dump schemes, can artificially inflate prices and attract unsuspecting investors
• Examples of information asymmetry and market manipulation include:
  1. The Enron scandal, where executives concealed the company's true financial condition
  2. The manipulation of stock prices during the penny stock boom in the 1980s

Lack of Transparency and Inefficient Regulation

• Lack of transparency and inadequate disclosure of information can hinder the ability of investors to accurately assess the fundamental value of assets
  • Companies may not provide sufficient or reliable information about their financial health, business prospects, or risk factors
  • Opaque market structures and complex financial instruments can make it difficult for investors to understand the true nature of their investments
• Inefficient market regulation and supervision can fail to prevent or detect the development of asset price bubbles in a timely manner
  • Regulatory bodies may lack the resources, expertise, or authority to effectively monitor and control market activities
  • Inadequate regulation can create loopholes and opportunities for market participants to engage in speculative or manipulative behavior
• Market inefficiencies and information asymmetry can lead to the misallocation of capital and the formation of bubbles in specific sectors or asset classes
  • Investors may pour money into overvalued assets based on incomplete or misleading information
  • The lack of transparency and efficient regulation can allow bubbles to grow unchecked until they eventually burst
• Examples of lack of transparency and inefficient regulation include:
  1. The opacity of the derivatives market prior to the 2008 financial crisis
  2. The inadequate regulation of the subprime mortgage market during the housing bubble