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Irrational Exuberance

Amplification Mechanisms: Naturally Occurring Ponzi Process

The effect of the precipitating factors listed previously is magnified by mechanisms involving investor confidence, investor expectations for future market performances and related influences on investor demand for stocks. These can be described as a naturally occurring Ponzi Process. These mechanisms work through a sort of feedback loop.

 

HIGH INVESTOR CONFIDENCE

A prominent feature of the recent bull market has been the high level of investor confidence in the stock market. People's belief in the flexibility of the market seems to stem from a generalized feeling of optimism and assurance, rather than a belief in the long-run stability of prices. People do not perceive any real downside risk, which explains their willingness to buy stocks even when, by traditional measures such as price-earnings ratios, are so greatly overvalued.

 

SOME REFLECTIONS ON INVESTOR CONFIDENCE

The numerous cases of persistent bad performance in the stock market history are not eminent in the public mind. The reason that the recent domestic market performance is more prominent is simply because they have experienced these. By presenting successful investing as a process of mastering one's own internal impulses rather than taking into consideration our present situation in history - it invites the investors to forget about the present levels of the stock market. An important reason behind today's strong investor confidence is the unstoppable rise in the Consumer Price Index (CPI), which has put an upward pressure on prices of all commodities. 

 

EVIDENCE FOR UNDIMINISHED EXPECTATIONS DESPITE A HIGH MARKET

Despite a fiercely rising stock market over the past couple of years, average expectations among high-income individual investors have also been rising. The Paine Webber/ Gallup polls have reported much more optimistic average expectations among individual investors. Altogether, expectations for the market among most investors are not so extravagantly high as was suggested by some of the polls. But expectations do appear to be a bit higher and at least remain as powerful as they were in 1989, despite a very high market.

 

SOME REFLECTIONS ON INVESTOR EXPECTATIONS AND EMOTIONS

Economists usually like to imitate people by calculating their investment decisions as accurately as possible, based on presumptions of future price changes and estimates of the risk in alternative investments. Investors often feel that the experts have little or no idea what to expect of future price changes or how much risk there actually is. Investors must therefore base their judgements on basic principles on which most experts agree upon. The feeling that the stock market is "the only game in town" in some emotional sense, plays a pivotal role in the decision-making of investors. How one feels about the stock market at any given time certainly depends on one's recent experience in investing. The psychological cost of a potential future loss may not be so much greater relative to the very real regret at having been out of the market in the past. The emotional state of investors when they decide on their investment is without a doubt the most crucial factor giving rise to the bull market.

 

 PUBLIC ATTENTION TO THE MARKET

The magnitude of public interest and attention to the market changes conspicuously over time. Writers such as John Kenneth in his book "The Great Crash :1929", have indicated that 1929 was a time of dramatically heightened investor attention to the stock market. Over the 1920s the percentage of articles about the stock market almost quadrupled. Another source of evidence on investor attention to the market is the increasing number of investment clubs. The crude conformity of the number of investment clubs to the performance of the market is noteworthy, suggesting that investors' attention is indeed attracted by bull markets. Economists Statman and Thortey state that the persistent effect of returns on volume is due to the impact of higher returns on investor confidence. It is a tendency for investors to interpret their investing success as confirmation of their own abilities, which in turn reinforces their interest in trading stocks.

 

FEEDBACK THEORY OF BUBBLES

In feedback loop theory, initial price increases influence more price increases as the earlier price increases creates a surge of demand. This increased investor demand transforms into a sort of a loop where the price keeps on increasing. The phrase "speculative bubble" appears to refer to such a feedback. Feedback theory can occur due to –

 

a) Adaptive expectations feedback that takes place because past price increases generate expectations of further price increases.
b) Increased investor confidence occurs in response to past price increases.
c) The theory of habit formation as proposed by economists John Campbell and John Cochrane.
d) Negative price bubbles can also occur, in which initial price declines discourage investors causing further decline and so forth.

 

PERCEPTIONS OF FEEDBACK AND BUBBLES AMONG INVESTORS

It is natural to wonder whether public perceptions of such a speculative bubble might be influenced by the recent high asset prices. Shiller finds little evidence that people have been thinking, during the recent market highs, that we are in a temporary speculative bubble. The prominent feature of the current high pricing is high confidence that the market will perform well.

 

PONZI SCHEMES AS MODELS OF FEEDBACK AND SPECULATIVE BUBBLES

In order to prove that feedback mechanisms do play a role in financial markets, the Ponzi scheme is examined. By means of this scheme, fraudsters pose as the managers of a scheme and promise to make large profits for investors by investing their money. But little or no investment in any real asset is actually made. Instead, the manager pays off the initial investors with the proceeds of the second group of investors, the second with the third and so forth. The perpetrator may then hope to exit without paying the last and largest round of investors and then hide from the law. 

 

SPECULATIVE BUBBLES AS NATURALLY OCCURRING PONZI PROCESSES

It can be deduced that speculative feedback loops are in effect naturally occurring Ponzi schemes without the involvement of a fraudulent manager. When prices go up a number of times, investors are rewarded, just as they are in Ponzi schemes. There is no direct manipulation, but the backstory is almost similar.

 

IRRATIONAL EXUBERANCE AND FEEDBACK LOOPS TODAY

Perceived long-term risk is down. Expected returns on investments are not down, despite a high-flying market. Emotions and heightened attention to the market create a desire to get into the game and get away with profits. Such is the irrational exuberance today in the United States. As prices continue to rise, the level of exuberance is intensified by the price rise itself.

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Units 4/13