Monday, November 1, 2010

How Do You Know If It's a Bubble?

A few weeks ago I felt compelled to respond to all of the talk that gold was in a bubble. Link here. In brief, I suggested that when everyone says it’s a bubble, it can’t be a bubble.

Yet, if you had a foolproof way to know when a market is in a bubble and when it is just going up, that is, when a rally is sustainable and when it is about to crash, you could become very rich indeed.

Thus the interest in Jonah Lehrer’s report about research into market bubble psychology conducted by Read Montague at the Baylor School of Medicine.

Montague and his colleagues have discovered how and why we get caught up in bubbles. They have gained new insight into how we fall prey to market exuberance and they have discovered a way to identify bubbles by testing the brain’s biochemistry. Link here.

I am not quite as optimistic as Montague when he suggests that the Fed can stop bubbles by buying a brain-scanner. But I can imagine a few hedge fund managers who are currently ordering brain scanners.

Montague's research shows that when you are actively participating in a market that is going up you will want to invest more and more of our money in it.

One might say that in those circumstances the rational and irrational portions of your brain are in synch or in harmony. Your rational mind sees profits and your irrational mind does not see any inordinate risk. So you decide to keep investing.

When a bubble starts forming, however, your rational mind will still be telling you to stay in the market. Your irrational mind, however, will be sending out warning signals.

This means that your rational mind will begin to come into conflict with the part of the mind that is telling you to get out. And its vaunted rationality will then work to prevent you from taking the kind of action that would protect you from the danger.

Your rational mind might be telling you that you are really, really smart, and that your run of good luck is not just a matter of luck but a function of your superior abilities as an investor.

If your rational mind is aware of the message that your irrational mind is trying to communicate, it might believe that it is in conflict with the forces of irrationality and they it must suppress or control them.

It may do so by labeling those fears irrational, and then dismissing them as the product of a childhood trauma.

I do not wish in any way to question the science behind the research. I would, however, be more cautious about using the terms rational and irrational.

Why should we think that the part of your mind that is attuned to reality and that is trying to warn you of danger ahead is irrational? True enough, its message does not seem to have originated in conscious thought, but it is certainly better tuned in to reality.

And I would question why we should call the part of the mind that ignores reality and tries to point you toward perdition should be honored by being called rational.

Therapists used to think that people suffering from anxiety and phobias were irrationally afraid. And they used to think that the rational mind needed to take control over the irrational part… because if patients were not afraid of anything real then they were re-enacting scenes of childhood terror. They needed to psychoanalyze their irrational anxiety.

The old theories used to see the mind in conflict between the rational side and the irrational side. Beginning with Freud therapists allied themselves with rational thought in its war against irrational impulses and thereby presented themselves as enlightened men and women of science.

But, what if this supposedly irrational side of your mind is telling you the truth. What if, when you start feeling a twinge of anxiety, your mind is alerting you to a danger that you are ignoring?

Call it irrational if you wish, but this part of the mind is simply in better touch with certain realities than is your conscious mind.

After all, Aaron Beck made an important observation when he said that phobics are usually afraid of things that represent real dangers. Being afraid of heights, spiders, crowds, blood, and enclosed spaces is perfectly rational, and perfectly adaptive. People who are unafraid of snakes and crocodiles probably have a shorter life span than those who are afraid.

The fact is, all of these phobia-inducing objects are objectively dangerous.

The phobic is not afraid of nothing; he is not repeating an unprocessed infantile fear. He is overly sensitive to a real danger, not delusionally afraid of something that is not a danger at all.

So, I cannot entirely agree with the idea that different parts of the mind compete with each other for dominance. Some people believe that these different parts of the mind are engaged in some kind of argument, one that will have a winner and a loser.

I would prefer to think of the different parts of the mind as seeking harmony. The part of your mind that is warning you of danger is not your enemy. It does not need to be controlled or reined in. It needs to be acknowledged and heeded. If the message is unclear or confused, your rational faculties should go to work to make its warnings make sense.

If you think that the part warning you of a bubble is irrational, you are also saying that the part telling you not to sell your inflated assets is rational.

In effect, if reason brings us into closer touch with reality, when confronting a bubble, the two parts of the mind have merely changed roles.

The rational part has been transformed into an irrational defender of bad judgments while the irrational part, the part that operates outside of the normal bounds of conscious reflection, has become the only rational indicator of danger.

The mind has great difficulty understanding that its rational faculties can be enlisted to support bad decisions, almost as though they were devils disguised as angels. At those times we need to ignore the voice of reason, because it is not really very reasonable and embrace the irrationality that is warning us of pending doom.


Chuck Pelto said...

TO: Dr. Schneiderman, et al.
RE: All Infantrymen Are...

Therapists used to think that people suffering from anxiety and phobias were irrationally afraid. -- Stuart Schneiderman

....therefore 'irrational'.

Well. That makes some sense. After all, you have to be crazy to go into the infantry.

But what does it mean when the 'crazy people with guns' are protecting the rest of US from the crazier people with bombs and scimitars?


[A healthy sense of paranoia keeps a soldier alive on the field of battle. -- CBPelto]

P.S. After all....

....they really ARE 'out to get you'.

The Ghost said...

I would point out that in most previous bubbles very few professionals called it in advance. Most of them became famous AFTER it crashed becasue of their insight. Unfortunately too many pro's are always calling the bubble and like a stopped clock they are right once in a while. The real swami's are the guys/gals who participated in the bubble and then reversed course at some point in the run up.
The problem with looking into your own mind is that you or I do not have enough information. This is why command based economies fail. The information that drives the economic decisions of millions of people are never the same but cover thousands of different signals that drive each individuals decision process.
Most bubbles start out on good fundamental economic foundations that slowly but surely are ingored or discounted over time when the fundamentals are no longer sound. Too many pro's will claim that a particular run up is different and give excuses why the old fundamental measurements don't apply "this time" ... those people need a brain scan because they are lying to themsleves at that point ...

Chuck Pelto said...

TO: All
RE: Speaking of 'Bubbles'

Some years ago—about 10—I read a book on the famous 'bubbles' of not-so-recent history: the Mississippi Bubble in France, the South Sea Bubble in England. The Dot-Com Bubble in America and the Real Estate Bubble in Japan paralleled them in just about everything, except geographic location and particular 'focus'.


[If history continually repeats itself and we never seem to learn from it, what does that say about us?]

Jim said...

"...we learn from history that we learn nothing from history" Hegel

I can't tell you how many times someone has discovered a new "holy grail" that will enable us to time the market in either stocks, bonds, gold, silver, et al. I've worked in accounting positions in trading companies that had all kinds of experts on the payroll whose job it was to forecast market directions. The more honest and wise ones would tell me (off the record of course)that "It's my best guess but I really don't know for sure...". Since only God seems to know what will happen, it almost seems blashpemous to claim to predict with certainty the directions of markets--

Romans 11:33. "Who can know what God is thinking? Who can be his counselor?"

If God's decisions are unsearchable and someone claims to know what God is thinking in secret, isn't that kind of arrogant? The idea of using brain scans to predict market highs makes about as much sense to me as using astrology.

Obsidian said...

Hi Doc,
Off topic, bit given how much I know of your keen interest in our President, I thought you might be interested in my latest post on the matter:

Would love to get your reaction. Thanks!

The Obsidian

Stuart Schneiderman said...

Actually, I agree that no matter what the neuroscientists discover we are still going to have market bubbles.

Yet, I do not think that the value of the research lies in whether or not the Fed buys a brain scanner and uses it to prevent bubbles.

I agree that precious few people escape the madness of crowds and the thrill of making a fortune (albeit, on paper). Some few do, and they are, as you say, swamis. They are the ones who allow themselves to pay attention to that inner voice that tells them to bail out before it is too late.

That's why I thought that perhaps hedge funds would buy the machines in order to improve their trading.

Then again, as some of you are suggesting, what would happen if all the hedge funds had the same machines and hooked all of their traders up to said machines? Would the machines start giving false readings?

It is well enough known that once the investing world finds a foolproof sentiment indicator, and too many people follow it, to ceases to work as evidence of contrary sentiment.