Theories of Bubbles: An Overview

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So which of these theories is correct? When it comes to recent bubbles in the housing and dot-com markets, I find behavioural explanations most convincing. Reconciling these bubbles with rational investors requires the creation of a complex model that makes a large number of assumptions about the choices made by each group. In contrast, once we assume that financial and asset markets are not uniquely immune to herding effects, the emergence of these bubbles is intuitive and self-explanatory. In accordance with Occam's Razor, the fact that the behavioural hypothesis requires so few assumptions makes it the most likely explanation; in other words, its strength is its simplicity.

The consequence of this hypothesis for identifying bubbles is outlined by Robert Shiller. When we see:

• The sharp increase in the price of an asset or share class
• Great public excitement about these price increases
• An accompanying media frenzy
• Growing interest in the class among the general public
• 'New Era' theories justifying the high price
• A decline in lending standards

It is likely that we are seeing the formation of a bubble.