Words such as “mania”, “bubble”, “panic”, “crash”, and “crisis” instantly evoke images of frenzied and probably irrational speculative activity.

Extreme prices that seem at odds with a rational explanation have occurred repeatedly throughout history. Tulip Mania, The 1929 stock market crash, Dot.com bubble and Global financial crisis are among the few examples when valuations seemed to be disconnected entirely from the forecasted observed performance.

In December, I would like to present discussions on the series of self-fulfilling bubbles – speculative bubbles. This article is a modest attempt to understand how each bubble alleviates the pain of the previous bubble, supports and justifies the next one.

It all always starts with the belief that the world has entered a new bright dawn of history which will liberate man from his life of want and struggle (Forbes, 2010). Despite the wide range of assets that have witnessed bouts of irrational exuberance (tulips, cryptos and equities, to name but a few), bubbles seem to follow a similar pattern. As Marx noted, history repeats itself, first as tragedy, second as farce.

A bubble exists when high prices seem to be generated more by traders’ interests than economic fundamentals. One thing interesting to observe is that a bubble is always defined ex-post. At some point, the bubble bursts, and the price adjusts downwards, sometimes very quickly. Interestingly, hindsight bias kicks in and tall claims made by investors/ traders that they knew it all along fall apart. But the question is why did they participate and lose money.

One of the most remarkable examples is the tulips bubble or the tulip mania of the 1630s. The tulip first appeared in western Europe in the 16th century. First, the wealthy, and then the middle class, became quite avid about the tulip, and soon high prices were paid for the rare tulip bulbs. Tulip demand seemed to escalate each year, particularly in Holland and Germany. By the 1630s, tulip markets sprang up in numerous cities with the sole purpose of facilitating tulip trade. Gambling and speculation seem to be taking hold, and many fortunes were made and then lost. Amazing stories of what goods people were willing to trade for you tulips have been recorded. The amount of goods often seems like a great deal to sell for a single tulip. Was the tulip mania a speculative bubble?

In hindsight, most would agree that people acted irrationally. What were they thinking? We may never know for sure, but one popular explanation is that people bought tulips because others would pay even more. According to the greater fool theory, you buy an asset that you realise is hyped because you think a foolish person is willing to pay even more. Maybe you are unwise, but there is a ‘greater fool’ somewhere.

However, we should not assume irrationality too quickly. Is a tulip fan who attaches a high value to a tulip bulb any more unreasonable than an art collector paying millions of dollars for a painting? Oddly enough but the high values associated with tulip bulbs could have been rationally based on people’s preferences during that period in history. The bubble burst possibly due to unexpected change in preferences – unlikely perhaps, but not impossible.

It is intriguing how people value assets in various markets, from tulips to stocks. Investors and academics alike strive to quantify asset values based on observable factors. Still, experience indicates that the human side has very real effects. Shiller argues that investing in a speculative asset is a social activity. Fashion, change in taste, change in risk attitude and what appears in hindsight to be simply irrational impacts the asset values

After stock price increases, the investors are less risk-averse because prior gains cushion subsequent losses. In contrast, the investor is concerned about further losses after stock price decreases and risk aversion increases. The result is higher volatility in stock prices. Changes in attitudes towards risk can significantly affect asset valuation and price changes—investors’ risk aversion increases after stock prices fall, reinforcing the drop in prices. In addition to higher risk aversion that might have resulted from downward market adjustments, perceptions of elevated risk seem to be widespread in recent months.

So, my dear readers, think whether cryptos are behaving like tulips or are you the tulip fancier? Would your ex-ante rational expectations of the future appear to be ex-post faulty?

“It is easy to say just be yourself, but you should always try to better yourself.”

Best Regards

 
Dr. Tarunika Jain Agarwal Ph.D.

Alpha Research