Tuesday, February 9, 2010

A Theory of Bubbles

Everyone has a personal discount rate that informs them and determines how much of their income they save and how much they spend, how much they invest and how much risk they will take. This will vary with income and expenses that they have become accustomed to, their wealth, changes in these, and with theirs and others perception of risk. The weighted sum of all these individual rates produce a market discount rate. Those with discount rates greater than the market I will call traders and those with ones less than the market, investors. Individuals may experience individual changes that move them between traders and investors, or changes in the market rate may move them from one to the other. While some movements are conscious and deliberate, others are often accidental and disconcerting and they will adjust their portfolios to return to their relative position.

Investors trade little and are mostly fully invested, but their flows into and out of the market are fairly steady forming slowly changing trends that are part of long term investment fundamentals. Traders trade often setting market prices at any given moment and their shorter term focus leads them towards short term value or momentum investing. An investment that starts out fairly valued according to long term fundamentals may experience a some unexpected good news. Traders will become encouraged and bid up the investment. Others will see the increase and bid it up more. The more that can be persuaded these represent long term fundamentals, the more investors will see it as less risky and join in, raising the price more. Eventually the number of new investors that can be persuaded diminishes, possibly due to exhaustion of supply or some less positive information. Value traders will have begun seeing it as overvalued and began selling. Prices after holding steady for a while will begin to fall. Momentum traders sensing weakness will shift from long to neutral and eventually short causing them to fall further. Some investors realize those weren't long term fundamentals, come to see it as riskier than they thought, or realize their risk tolerance is lower than they thought and sell more. Eventually the number of investors that were actually traders falls through attrition and declines slow. Value traders come to see it as undervalued and begin buying. Momentum traders sensing strength will shift from short to neutral and eventually long. Prices will once again rise to their long term fundamental value. This appears as short term embellishments on long term trends.

The price changes caused by traders are large compared to variations in long term fundamentals but usually small compared to what is called a bubble. Yet these microbubbles seethe almost continuously keeping the market perking. For one to get large by market standards some conditions usually must be present. A long period stability can encourage the dismissal of risk. Lower interest rates can provide a notable initial bump. Innovation and a story can obscure fundamentals and cause investors to believe in a new era and this time is different. A large number of increasingly wealthy but inexperienced traders believing themselves investors that entrain themselves into the bubble without much fear of loss. Once one bursts, it can be difficult to reinflate since they have lost a sizable amount and become highly skeptical of any new one, at least in the same asset class, while those who profited have to resort to trading in a new asset class they are less familiar with in the hope of finding more. Eventually traders are faced with the more difficult prospect of profiting at each others expense, trading success and interest diminish, and after a long while, after it proves itself again, long term investing comes back into favor.