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Housing Bubble Market Psychology

Posted: 26-12-2008 | Views: 216

Financial markets are driven by fear and greed: two basic human emotions. Rationality and careful analysis are not responsible for, or predictive of, current or future price levels in markets exhibiting bubble pricing as the emotions of buyers and sellers takes over.

The psychology of speculation drives bubble markets, and because of the nature of fear and greed, most speculators are doomed to lose their money. In contrast, true investors are not subject to the emotional cycles of the speculator, and they are more able to make rational decisions based on fundamental valuations. Of course, many investors also miss the excitement of a runaway price rally in a speculative bubble.

The Great Housing Bubble was inflated by people trading houses. Residential real estate took on the character of a commodity, and it became subject to the same chaotic price gyrations as a speculative commodities market. This behavior was caused by lenders who provided the financing terms which enabled speculators to use mortgages as option contracts with the risk of loss being transferred to the lenders.

With any loss, an individual must go through a grieving process. Since markets are the collective actions of these individuals, markets experience the same psychological stages which are apparent in the price action. Efficient markets theory attempts to explain market price action through the collective action of rational market participants. This theory fails to explain the irrational behavior exhibited in bubble markets. Behavioral finance theory seeks to explain irrational exuberance.

The price action in a bubble has other impacts on the beliefs and behaviors of individuals and society as a whole. These beliefs and behaviors may become pathological in nature leading to suffering and social problems. As with any form of mass hardship, there are calls for government action which lead to proposals for bailouts and false hopes among the populace.

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