Bubbles – in Theory and in Markets

Should we invest in bubbles? Depending on the nature of the bubble, there are different prescriptions for investors. Seminar on 6 February 2018 at the Swedish House of Finance.

A common misunderstanding is that academics believe in efficient markets, thus, there is little academic interest in bubbles. This is far from the truth. First, academics in general do not argue that markets are efficient. Second, even proponents of efficient markets think market prices can be dislocated temporarily. In fact, there is a large academic literature on bubbles. The problem is that there are too many papers on them to follow for nonacademic people. In this seminar Jungsuk Han, Associate Professor of Finance, selectively review academic literature on bubbles by choosing those papers that may be practically useful.

 

The ultimate question of the seminar was whether to invest in bubbles. To answer this question, we should consider both theoretical and empirical sides of academic literature. Theoretically, there are various types of bubbles, and there is no investment strategy that fits all. Depending on the nature of bubbles, it gives totally different prescriptions for investors. On the empirical side, there are plenty of methods of testing and detecting bubbles, but the results are not at all conclusive. Some methods may be handy in some cases. In most cases, however, we won’t get much practical guidance – particularly about deciding whether to invest or not.

 

Jungsuk Han started the seminar by discussing theories of bubbles. He categorized them in different types so that we can think about separate investment strategies. Along the way, he also discussed other theoretical aspects such as welfare and policy implications.

 

Second, he discussed why bubble is such an elusive concept. There is a lack of consensus on the terminology, but a closer look at it reveals that it is not just a matter of agreeing on the definition. There is a deeper reason why we cannot agree on bubbles. Third, he discussed whether researchers successfully identified historical bubbles, or can identify on-going bubbles. The main difficulty arises from the fact that we do not know the actual fundamental value. Therefore, most of existing test methods resort to an indirect way which does not involve the direct measure of fundamental value, but it surely comes at a cost.

 

He also went over some empirical discussions about who made profits or losses during historic bubble episodes. This may shed a light on investment strategies we should adopt during bubbles. Finally, he applied the discussion to the case of Bitcoin which is one of the hottest topics in today’s market.

 

As a concluding remark, he argues that bubbles are not all bad contrary to the common perception. In fact, we should invest in certain kinds of bubbles – but not all kinds of bubbles. Those kinds of bubbles either never burst or at least offer proper risk premium for bearing the risk of burst. But, this does not mean that we should invest in all bubbles. There are surely some bubbles we should avoid unless we can time the market. However, timing the market with a bubble seems to be a bad idea unless one is equipped with clear advantage like fast trading or private information, etc. Furthermore, one should be careful about overconfidence as evidence suggests. Finally, bubbles may be beneficial to economic welfare in certain cases although they are usually harmful due to the misallocation of resources.

 

Information about the seminar:

Jungsuk Han, Associate Professor of Finance at the Stockholm School of Economics will give a non-technical overview of the theory of Bubbles. Are bubbles rational? How can we identify a bubble? Why do they start and persist? How do they end? How do they affect the economy? What do we know about different bubbles such as stock market bubbles, housing bubbles, or Bitcoin bubbles?

Torbjörn Iwarson, Commodity Market Specialist at Skandia Investment Management will comment on the occurrence of Bubbles in the markets. There will be plenty of time for discussion with the audience.