“What people are really good at is learning about events that they experienced personally, over and over again,” says Dr. Huettel, the Duke neuroscientist. “You aren’t going to get snookered by the same person in poker many times in a row because you pick up on irregularities.”
While bubbles seem to share general characteristics, we convince ourselves of even the slightest differences. For instance, the current tech bubble can be rationalized because it is predicated on the proliferation of social media, not the growth of the Internet.
There is also a lot of evidence that the surge of testosterone traders experience during a speculative rush can cloud decision-making.
John Coates, a Canadian-born research fellow in neuroscience and finance at the University of Cambridge and a former trader at Goldman Sachs and Deutsche Bank, has run experiments on trading floors in the City of London.
“Once you start making above-average profits, as most people do during a bull market, you start getting this high,” he says. “I think it’s enough to pretty much squash memory” of previous bubbles.
His new book, The Hour Between Dog and Wolf, details these findings and ties them back to what the behavioural economists started studying years ago.
Prof. Coates admits that even he, someone equipped with a PhD in economics from Cambridge, has fallen victim to the testosterone highs. “I don’t think I ever would have hit on this if I hadn’t experienced it myself,” he says. “We have an unstable biology, and it’s very powerful.”
Yet there are people – even whole firms – who appear to effectively game these bubbles. At a recent luncheon, Prof. Holt, the University of Virginia behavioural economist, had a conversation with a successful hedge- fund manager who confided that he did not trade on companies’ long-term fundamentals.
Instead, he looked at the previous seven days of trading and read newspaper headlines and television talking points, going by the theory that economist Burton Malkiel espoused – that “a blindfolded chimp throwing darts at the Wall Street Journal” had a 50-per-cent chance of beating the market, because humans are so subject to their irrational psychology.
The question, then, is whether humans can control their urges. Prof. Holt himself admits that even after studying bubbles for decades, he ultimately bid on a $1.2-million house at the height of the U.S. housing bubble.
Luckily for him, he backed out at the last minute because his father, an engineer, caught some structural problems during an inspection.
Human biases are “so ingrained that just knowledge isn’t enough to overcome them,” Dr. Huettel says.
“From an evolutionary point of view,” says Caltech’s Prof. Camerer, controlling urges “basically isn’t something that any other species needed the capacity to do.” Add in the financial incentives on Bay Street and Wall Street, and we practically jump at bubbles.
For traders, “there’s no downside to rolling the dice,” Prof. Coates says. “Bubbles occur once every five years, but in the meantime you’ve pocketed four bonuses, and you don’t give them back.”
Can we game the system?
There certainly are individual exceptions. Prof. Holt chuckles when he recalls that behavioural-economics pioneer Vernon Smith had bought a beautiful penthouse apartment near George Mason University in Virginia. A few years after Prof. Holt visited it, he asked some George Mason researchers what happened to Prof. Smith’s apartment. They said he had sold it because he realized the market was getting too heated.
Where Prof. Holt had almost bought a million-dollar home at the height of the bubble, Prof. Smith had smartly sold into the rally.
Collectively, though, behavioural economists and their neuroeconomist colleagues have had trouble coming up with theories of how to curb speculation. Prof. Coates, for example, advocates government intervention in the aftermath of a bubble, but he doesn’t see how the government can step in when things are too hot.
In his research, he found that in a bear market, when asset prices are falling, cortisol – testosterone’s hormonal opposite – floods traders’ bodies and inhibits them from taking on any type of risk.
Under those conditions, he says, governments must step in and facilitate trading for a short period to stabilize the markets.
But when the market is too frothy, he says, it would be very hard for regulators to tell investors the fun was over: “It’s very difficult to take away the punch bowl.”
In absence of any surefire cure, however, the underlying consensus is that acknowledging the pervasive influence of irrationality would be a start.
Glancing at the bestseller lists, it would appear that this message has caught hold – books such as Thinking, Fast and Slow, Nudge and even Freakonomics have sold scads of copies. Yet the people who read them often assume that it is everyone else who is irrational.
Instead, like an alcoholic trying to get clean, the first step is for each of us natural bubble addicts to tame our egos and admit that we have a problem.