Financial Bubbles: Why Do Fools Fall in Love?

Like the poor, it seems that financial bubbles will always be with us. From the Dutch tulip mania of the 17th century to the dot-com bubble of the late 1990s to the real-estate bubble of the 2000s, something in our nature drives us ceaselessly to chase the next big thing — right off a cliff.

But what makes this cycle repeat itself over and over and over again? Why can’t financial regulations tame this beastly side of human nature? And don’t people ever learn from their mistakes?

The answer to that last question is key: They do, but only slowly, and each new generation needs to learn for itself — at least when it comes to financial assets.

That’s because financial assets are a rather odd kind of good for humans to wrap their minds around. When it comes to real goods, it’s relatively simple for the average person to decide what he or she is willing to pay for something. For cars and refrigerators, it’s about what they’re willing to pay. The stock market, on the other hand, is about what someone else is willing to pay. And, going by the bigger-sucker theory — I may have overpaid, but a bigger sucker will take this asset off my hands — you can almost always justify paying a little more if you’re sure an asset’s price is heading up.

And in a bubble, people are always sure the price is going up — even when they know its fundamental value remains unchanged.

This was demonstrated rather brilliantly by an experiment first conducted in the mid-1980s by Nobel Prize winner Vernon Smith, the father of experimental economics. Smith found a way to recreate asset bubbles in the lab, by giving groups of volunteers money and shares to trade in a miniature stock market conducted over trading screens. While the fundamental value of the shares is held constant, and everyone has the same information, the participants nonetheless bid up the price of the shares. Instead of figuring out the shares’ fundamental value, they try to buy low and sell high. A bubble is created, and around the 15th round it pops. This happens roughly 90% of the time.

If you run the experiment repeatedly on the same group, however, they eventually seem to learn the lesson and stop creating bubbles around the third time through.

So, why don’t people in the real world seem to learn, even at this relatively slow pace? After all, it’s not as if the most recent stock and housing bubbles are the only ones we’ve ever seen. Smith says it’s a matter of one generation replacing the next. “One of the things that happens out there in the world, you keep getting new investors coming in,” he said. “We had a stock crash in October 1987, but 20 years later, who remembers that?”

But where does the urge to chase a rising stock price or rising home values come from in the first place?

Paul Zak, founding director of the Center for Neuroeconomics Studies at Claremont Graduate University, points to a number of quirks in our brains that might be responsible. One is that over-stimulation of the “reward” centers of our brains appears to steer us toward more risk. For instance, it’s been shown in laboratory experiments that men in a state of sexual arousal are more likely to make risky financial decisions. “Anything you see on CNBC likely activates this,” Zak said.

Another factor is how our brains experience regret when we see the money we could be making in, say, a rising stock market. In one experiment, subjects were imaged in an MRI machine while playing a stock-market investment game. If a person saw the stock market go up when they didn’t have much money invested in it, the scientists were actually able to see the “regret” signal in the subject’s brain. And the more regret a person felt, the more he or she invested in the market as the game went on. While this kind of “fictive learning” can be useful in other contexts, in asset markets it’s a recipe for disaster.

Lastly, Zak points to our basic evolutionary nature: “We’re a herd species. When the rest of the herd’s doing something, they’re all running in formation, it really seems like we ought to do that, too.”

So, how can you avoid being part of a herd headed to its doom? There’s no secret formula. The best you can do is understand when your brain is leading you astray and try to focus on fundamental value instead of the hunger to make a quick buck.

There’s an old Wall Street saying one might keep in mind: Bulls make money. Bears make money. Pigs get slaughtered.

Ryan Sager writes the blog Neuroworld at TrueSlant.com.