Behavioural Finance
The Psychology of Bubbles
How excitement, stories and social contagion inflate asset bubbles, what Robert Shiller's work shows, and warning signs investors can watch for.
From tulip mania to the dot-com boom and crypto manias, markets have repeatedly seen prices soar far above reasonable values and then crash. What drives these bubbles?
Shiller’s insight
Economist Robert Shiller argued that bubbles are driven by feedback loops:
- Prices rise.
- Rising prices attract attention and new investors.
- Their buying pushes prices higher.
- Stories spread explaining why prices will keep rising.
His book Irrational Exuberance, published in March 2000, warned that tech stocks were overvalued, just as the dot-com bubble peaked. A later edition warned about housing before the 2008 crisis. The phrase “irrational exuberance” came from a 1996 speech by US Federal Reserve chair Alan Greenspan.
Narratives
Shiller later emphasised narrative economics: stories that spread like viruses. “The internet changes everything”, “house prices never fall” and “crypto is the future of money” helped justify high prices.
Social contagion
- Fear of missing out: seeing friends get rich creates pressure to join.
- Media coverage amplifies success stories.
- New investors with little experience enter late.
Warning signs
- Prices far above historical measures, such as Shiller’s CAPE ratio, which compares prices with average earnings over ten years.
- Talk of a “new era” where old rules don’t apply.
- Heavy use of borrowed money.
- A surge of inexperienced investors.
- Rising prices justified mainly by the expectation of further rises.
The difficulty
Bubbles are easier to spot in hindsight. High valuations can persist for years, and some “bubbles” turn out to be justified by real growth. Diversification and discipline protect investors better than trying to time the peak.
In late 1999, a guest at a dinner party talks about doubling his money in internet stocks. Others who have never invested decide to buy. Within months, the bubble bursts, and the latecomers suffer the biggest losses.
Even experts struggle to know when a bubble will burst. Diversification and discipline are safer than timing.
- Bubbles grow through feedback loops of rising prices and new buyers.
- Robert Shiller warned about both the dot-com and housing bubbles.
- Narratives and social contagion fuel bubbles.
- Warning signs include high valuations, "new era" talk and heavy borrowing.
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