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The pre-market price for Facebook stock is shown, Wednesday, May 23, 2012 at the Nasdaq in New York. Facebook stock rose in early trading, although still far below the $38 it was priced at before its initial public offering. (Mark Lennihan/Mark Lennihan/AP)
The pre-market price for Facebook stock is shown, Wednesday, May 23, 2012 at the Nasdaq in New York. Facebook stock rose in early trading, although still far below the $38 it was priced at before its initial public offering. (Mark Lennihan/Mark Lennihan/AP)

Why do we keep falling for economic bubbles - and will we ever learn? Add to ...

The guessing game of how much Facebook would ultimately be worth started long before the social-networking behemoth officially announced that it would become a public company. In early 2011, when Goldman Sachs bought a small stake, there was word that the site could be worth $50-billion (U.S.). Then last June, less than six months later, news network CNBC upped the ante to 12 figures on air, dubbing the company America’s “$100-billion baby.”

The general public devoured the speculation – investors believed that because they and everyone they know use Facebook incessantly, it must be worth an exorbitant amount. When it made its initial public stock offering a week ago, its valuation lived up to the hype at $104-billion – only for the stock price to drop nearly 20 per cent after three days of trading. On Wednesday, angry investors launched a class-action lawsuit charging that Facebook and its underwriters made “false and misleading representations” before the initial offering.

Was this a bubble bursting, or at least showing signs of strain? Companies in the social-media business have been getting scooped up for jaw-dropping amounts, despite often-remote potentials for profit. (Facebook itself recently bought Instagram, a smartphone photo app with zero revenue, for $1-billion.)

For those who lived through the fallout of the last tech bubble, in the late 1990s and early 2000s, this looks very familiar: Barely a decade ago, irrational expectations of Silicon Valley ended up sending the U.S. economy into recession; investors got hosed when the Nasdaq, the main market for tech listings, lost more than three-quarters of its total value. It is mind-boggling that we are back here so soon.

Such behaviour seems all the more absurd when you look back at the plethora of bubbles in history: People have fallen for everything from Holland’s “tulip mania” in the 1600s to the vicious Japanese housing bubble in the 1980s and the North American one that burst in 2008. We’ve even succumbed to mini-bubbles of frenzied speculation around trivial things, such as the Beanie Baby toy bonanza of the late 1990s. If humans are supposed to be the most intelligent species on Earth, shouldn’t we have learned our lessons by now?

Apparently not. University of Virginia economist Charles Holt ran an experiment that asked a group of subjects to buy and sell a fake asset, attempting to make the most profit. Previous runs of the test had often revealed bubble-like behaviour.

This time, though, smack in the middle of the simulation, one of the participants unexpectedly calculated the asset’s intrinsic value, based on its documented profits, and shouted it out. Mr. Holt assumed the experiment was doomed – surely everyone now would just buy and sell the asset at its true price.

But soon he saw something he could barely believe: Students started to buy at higher prices again; not long after, the person who had run the numbers started doing the same. Ultimately, they all traded based on what everyone else was doing, rather than what the numbers showed.

Experiments of this type are common in the school of behavioural economics. Butting heads with classical theory, these economists’ work is predicated on psychology and biology, not computer models.

While the field has been around for decades, its work is only now going mainstream, buoyed by technological advances that have allowed neurologists to study what happens to human brains in a bubble and adding scientific research to back up the behavioural economists’ theories.

Their message is simple: If we’re ever to avoid the “irrational exuberance” (in former U.S. Federal Reserve chairman Alan Greenspan’s famous phrase) that accompanies economic bubbles, we’ll have to get a better handle not on market forces, but on our brains.

A fatal formula: envy, overconfidence and habit

At 85 years old, Vernon Smith is one of the grandfathers of behavioural economics. A Nobel Prize winner, he is renowned for toying with theories of irrationality as early as the 1960s, when it was practically unheard of to question the crux of classical economics – that the economy is composed of rational actors following their self-interest.

One of his experiments asked subjects to bid on an asset whose value dropped by the same amount in every round of the simulation – a scenario similar to what a mining firm experiences, because its value drops every time it digs another ounce of its resource out of the ground.

Because the simulation’s linear trend was so easy to decipher, the subjects should have picked up on it quickly. But they didn’t. Comically, they made themselves believe that they could unearth some hidden value, and continued to bid up.

For decades, experiments of this sort have clearly shown that the subjects do not act rationally, but it has always been hard to pinpoint why. Study after study has highlighted a set of dominating characteristics that drive our behaviour in bubbles: envy, overconfidence and a reliance on past performance as a predictor of future gains.

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