A brief introduction of bubbles

Bubble is a phenomenon that the market price drifts away from its fundamental price. Large bubbles are rare but little bubbles happen all the time. We have experienced large bubbles several times, such as the Tulip Mania in the 17th century, the South Sea Company in the 18th century, the most recent 2007-8 Subprime Crisis. The bubbles could be put into four categories: rational/near rational bubbles, informational bubbles, intrinsic bubbles, fads.

For rational bubbles, the bubbles increase at the same rate as the interest rates when the assets have infinite maturities. In addition, there is a possibility of bubble bursts at each period. When the possibility of bubble burst increases, there is a need for high asset prices (high capital returns) compensate the high risk. This will lead to a great fool market that investors believe they can exit the market at the right time. For near rational bubbles, when investors are unrealistically overconfident, overoptimistic and myopic risk aversion, it will also contribute to create bubbles.

For intrinsic bubbles, investors overreact to the news about fundamentals. Stock prices are more volatile than dividend changes, so prices overreact to dividend changes easily.

For informational bubbles, if the market price is informationally efficient, there is no economic incentive to collect private information. Investors need to choose whether they collect their own private signals and respond to their private signals or just copy what the other investors (their trusted friends, colleagues) are doing.

For fads, investors sometimes believe there is a new fashion that we enter a new era. For example, the Dotcom bubble was created based on people's belief that we were entering the "Internet Era".

There are three theories that explain how bubbles arise: belief-based theories, preference-based theories and a speculative model (Shiller 2002). The belief-based theory suggests there is an extreme bullish view and there is an extreme bearish view, because of the short-sale constraint, the market reflects more about the bullish view rather than the bearish view, so the market price is overvalued. The preference-based theory suggests investors may have a strong preference for lottery-like payoffs, this would overvalue these stocks. Shiller suggests the essence of a speculative bubble is a sort of feedback, from price increases, to increased investor enthusiasm, to increased demand and hence further price increases. Behavior bias contribute to the feedback system: the representativeness heuristic, overconfidence, attention anomalies, self-esteem, conformity pressures and salience.

It is very difficult to spot a bubble, but bubbles commonly burst after a sharp price increase.