Market bubbles that cause financial crises may be perpetuated, or even created, because people instinctively try to predict how the behavior of others will affect the market, according to a new study from a team of American researchers.
Bubbles are created when the trading of a particular product or asset reaches prices that outpace their value, and usually results in a market crash, such as in the "dot-com" bust of the early 2000s. To measure how people's behavior contributes to the creation and growth of market bubbles, researchers at the California Institute of Technology monitored the brain activity of a group of students while they watched replays of market activity and were instructed to buy, sell or keep their assets. Their findings were published online Wednesday in the journal Neuron.
"Sometimes you get a bubble, which means prices are too high, and then they get even higher, which is really the interesting phenomenon. Are people being stupid? Or it might be that they think … 'I'm going to buy now and sell before it crashes,'" says co-author Colin Camerer, a professor of behavior economics at Cal Tech. "Some of the people are right, and they actually make a lot of money that way by purely speculating. The question is, who does that and why? What part of their brain is telling you, you should participate in this bubble and pay too much?"
The researchers found the formation of bubbles was linked to increased activity in the part of the brain that processes value judgments and is involved in decision making, he says.
But Camerer notess this result was expected because people are more likely to make decisions that will give them rewards. As such, people with greater brain activity in this area were more likely to ride the bubble, with the thinking there could be a chance for them to make money if they sold their assets before the crash.
But one thing the researchers did not expect to see was that in simulated bubble markets, there was also increased activity in the part of the brain that works to interpret social signals to infer the intentions of other people and try to predict their behavior, an act known as mentalization.
Camerer said he thought strong "mentalizers" – people who appear to be more intuitive and can more easily identify another person's emotions – would be more likely to figure out if the market is inflated and make better decisions based off that information. The team measured the participants' ability to mentalize by asking them to identify another person's emotion by looking at a set of eyes making different expressions. Still, they found that even those with strong mentalization skills rode the bubble.
"We were surprised because one thing about bubbles is those who are participating are not really thinking, they're caught up in a frenzy," Camerer says. "That's not exactly mentalizing, that's trend chasing or following the herd."
But the researchers found that when the participants noticed there was a disparity between trading rates and how much an asset was actually worth, they began making poor decisions by trying to theorize about other people's behaviors.
"It's a group illusion. When participants see inconsistency in the rate of transactions, they think that there are people who know better operating in the marketplace and they make a game out of it," co-author Peter Bossaerts, a professor from the University of Utah, said in a statement. "In reality, however, there is nothing to be gained because nobody knows better."
Being able to understand the mental aspects that contribute to the creation of market bubbles could lead to better interventions or indicators of when bubbles might be forming, Camerer says.