Market Bubbles & Crashes - Behavioral Explanation
Definition of Bubbles
Bubble: Asset prices rise far above fundamental value, then crash.
Characteristics:
- Rapid price appreciation (100%+ in 1-2 years)
- Disconnect from fundamentals
- "This time is different" narrative
- Widespread participation
- Eventual collapse
Famous Bubbles
Tulip Mania (1637): Bulbs cost more than houses → Crashed 99%
South Sea Bubble (1720): Stock rose 10x in months → Crashed 90%
1929 Stock Market: Rose 400% in 5 years → Crashed 89%
Dotcom (2000): Nasdaq 5x in 3 years → Fell 78%
Housing (2008): "Housing never falls nationally" → 40% crash
Crypto (2017): Bitcoin $20K → $3K (-85%)
Behavioral Causes
Overconfidence: "I know this will keep rising"
Herding: "Everyone's buying, must be good"
Availability Bias: Recent gains seem representative
Anchoring: New highs become reference, pull prices up
Feedback Loops: Price rises attract buyers → Prices rise more
Stages of Bubbles (Minsky Model)
Displacement: New opportunity (internet, housing)
Boom: Prices rise, attract attention
Euphoria: "This time is different!" rhetoric
Profit-Taking: Smart money exits
Panic: Rush for exits, liquidity vanishes, crash
Why Rational Arbitrage Fails
Limits to Arbitrage:
- Can't short enough (constraints)
- Timing uncertain ("markets can stay irrational longer than you can stay solvent")
- Career risk (fired if early)
Example: During 2000 bubble, rational managers shorting tech lost clients, were forced to cover. Bubble lasted 2 more years before collapsing.
Loading quiz…