dealing with asset bubble

8/9/2019 Dealing With Asset Bubble

1/11

CRISIL Young Thought Leader 2009

on

Dealing with asset bubbles

By

Mr. GOUTAM DASH

Master in Business Administration (IB), Second Year

GITAM INSTITUTE of INTERNATIONAL BUSINESS

GITAM INSTITUTE of INTERNATIONAL BUSINESS,

Rushikonda , VISAKHAPATNAM,

A.P., India 530 045.


2/11

2

TABLE Of CONTENT

EXECUTIVE SUMMARY 3

INTRODUCTION 4

HOW IT STARTS? 5

HOW MARKET SHOULD BEHAVE? 5

THE FASCINATING HISTORY OF ASSET BUBBLES:- 6

WHAT CAUSES BUBBLES TO BURST? 8

SUGGESTION 10

BIBLIOGRAPHY 11


3/11

3

EXECUTIVE SUMMARY

Have you heard of the saying Do not put your eggs in one basket, especially during the

stock market debates?? Sure you must have. And now we will utilise it for our topic, the

Asset Price Bubble. There have been so many investors-stakeholders who have come up

with various theories on diversification of a portfolio- advised by various broking and

advisory and consultancy firms on not to invest in a single stock or commodity. There is no

second doubt that today people believe and practise diversification, then, the question is

Why did the markets doom? Why was the whole world trapped in a liquidity crisis? Every

downfall in the market leads us new theories, new studies. It is of pertinent nature to get

back to the basics and find out where we went wrong. Let us study the major reasons

behind the abysmal state of the markets.


4/11

4

If history repeats itself, and the unexpected always happens, how incapable must Man be

of learning from experience? George Bernard Shaw

It is rightly said Do not put all your eggs in one basket. This is very much true in the

case of Asset Price Bubble. Many investors come up with so many theories to diversify the

portfolio in better ways, but still the boom happens and all the countries are wrapped in the

liquidity trap. So it is better to know why bubble occurs and what the major reasons are

therefore.

Financial asset bubbles are the most recurring in any financial crisis that the developing

and the developed nations face. Right from the 17th

century Tulip Bubble, the dotcom

bubble in Year 2000 and the recent sub-prime crisis, from which the world has still not

recovered, and each bubble burst shook the world every time as it wiped off with it

thousands of crores of money. It is very

difficult to follow a simple model or a strategy

to control market crashes. An economic model

differs from human psychology and it is really

true. We have seen a significance

improvement in the financial model for

investment right from Harry Markowitz with

the mean-variance portfolio theory; the most

used Capital Asset Pricing Model of Sharpe,

Rosss Arbitrage Pricing Theory and Black &

Scholes option pricing and hedging theory.

But still the stock market crashes.

A bubble is part of asset price movement that is unexplainable by fundamentals, or

factors that we believe drive the asset price movement. Bubble is the name assigned to

those asset price booms, which are inevitably followed by price tumbling and financial

instabilities/crises. It has been applied to different matters, consciously or unconsciously.

The misapplications are in two directions: 1) The term is often applied to all cases of asset

price boom, with no serious attention paid to whether they are followed by price tumbling

and financial instabilities/crises; 2) It is taken for granted that bubbles are the deviation of

market prices of assets from their true values.

We have seen a significance

improvement in the financial model

for investment right from Harry

Markowitz with the mean-variance

portfolio theory; the most used CapitalAsset Pricing Model of Sharpe, Rosss

Arbitrage Pricing Theory and Black &

Scholes option pricing and hedging

theory.
http://www.quotationspage.com/quotes/George_Bernard_Shaw/http://www.quotationspage.com/quotes/George_Bernard_Shaw/http://www.quotationspage.com/quotes/George_Bernard_Shaw/


5/11

5

HOW IT STARTS?

The bubbles journey comprises a smooth beginning with increasing demand (or

production and sales for a particular commodity) in an otherwise relatively optimistic

market. The attraction to stocks/scripts with good potential gains leads to increase in

investments, possible with leverage coming from novel sources, often from international

investors. This leads to price appreciation. This in turns attracts less sophisticated investors

and, in addition, leveraging is further developed with small down payment (small

margins), which leads to the demand for stock rising faster than the rate at which real

money put in the market. At this stage, the behaviour of the market becomes weakly

coupled or practically uncoupled from real (industrial and service) production. As the price

increases, the numbers of new investors entering the speculative market decreases and the

market enters a phase of larger nervousness, until a

point when the instability is revealed and the market

collapses.

Bubbles may also reflect investors reactions to

factors unrelated to fundamental economic and

business conditions. Hypothetically, individual

investors may rush into the stock market because

they believe everyone else is making money in the market. In this case, they prefer to buy

stocks immediately rather than miss an excellent buying opportunity. As a result, the

anticipation of rising prices becomes a self-fulfilling prophecy, and market participants

enjoy profits that may not necessarily reflect favourable business prospects.

HOW MARKET SHOULD BEHAVE?

There is also a debate on this i.e. how market should behave. Should it behave closely to

the fundamental values or whether market psychology and irrelevant factors can cause

prices to deviate substantially from assets fundamental value?

The fundamental value of an asset is usually defined as the present value of the expected

payoff from the asset. Market fundamentals, combined with the efficient market theory,

provides a simple tool for interpreting the fluctuations in security prices. According to the

The anticipation of rising prices

becomes a self-fulfilling

prophecy, and market participants

enjoy profits that may not

necessarily reflect favourable


6/11

6

efficient-market hypothesis (EMH) that financial markets are "information efficient", or

that prices of traded assets (e.g., stocks, bonds, or property) already reflect all known

information, and instantly change to reflect new information. Therefore, according to

theory, it is impossible to consistently outperform the market by using any information that

the market already knows, except through luck. Information or news in the EMH is defined

as anything that may affect prices that is unknowable in the present and thus appears

randomly in the future. This hypothesis has been attacked lately by critics, who blame

belief in rational markets for much of the current financial crisis. The EMH theory predicts

that the price of the companys stock would jump immediately as investors re-evaluate the

security in the light of new information. In long term perspective of the market we can say

that EMH is valid but in the short-run major shifts are caused by market psychology or

even the things which are not directly related to the business prospects or economic

conditions.

THE FASCINATING HISTORY OF ASSET BUBBLES:-

In the history of financial world, risk reward and catastrophe come as an irregular cycle

witnessed by every generation. Greed, hubris and systematic fluctuations have given us the

first aver asset bubble in history i.e. Tulip mania. This is just the beginning to a long

history. The South sea bubble, the land boom in the industrialisation era i.e. 1920, the US

stock market and great depression in 1929, the October 1987 crash for which analysts are

still to find a reason, the dotcom bubble in 2000 and

the subprime crisis of 2007-2008 have been the

addition to recent history.

The first known example of speculative bubble is thefamous Tulip Bubble. This is a history record from the 1620 through 1637. The

speculative bubble involved rare, collectible tulips. The tulips make part of the imports of

Holland before the 1600s. As time went by rarer and more valuable classes of tulips

emerged and became a desire item of wealthy Dutch people. Price of this product increases

tremendously. Additionally to these phenomena, Dutch speculator invented a new financial

instrument similar to what is known today as an option. The low cost of this instrument

was of great incentive for people from all social classes to give up their jobs and speculate

in tulip bulbs. The Bubble burst the moment people started pledging land and other asset

Greed, hubris and systematic

fluctuations have given us the

first aver asset bubble in

history i.e. Tulip mania.


7/11

7

for credit. Credit had been exhausted and people were unable to find buyers for their more

expensive bulbs making prices go down over 99% from their peak. A century later the

bulbs were virtually worthless.

1929 burst was definitely the largest crash in the US history. After the crash, stocks were

trading 90% below their 1929 highs and there was a tremendous rush by the investors to

liquidate their equity holdings. Federal Reserve encouraged New York banks to provide

the liquidity by decreasing the interest rates and allowing them to borrow at discount rates.

After the liquidity problem was solved in 1930, Federal Reserve increased interest rates to

encourage investors to buy government securities. Market took this action to be speculative

and the economic activity and stock prices kept declining leading to a recession. Although,

Federal Reserve was successful in the immediate actions it took right after the bubble, it

was criticized about the post 1930 policy. After the stock prices crashed in August 1929,

production fell by 50% and the overall price level declined by 30% until March 1933. It is

still argued that the Great Depression should not be attributed to the bursting of the stock

bubble.

After that the major crash took place in October14 1987. The reason for 1987 stock market

crash is yet to be discovered but the major reasons are

computer trading, derivative securities, illiquidity, trade

and budget deficits and overvaluation. Then the next

one is in the year 2000 i.e. DOTCOM bubble. One of

the main components of Internet bubbles is

GetRichQuick mentality that prevailed in the market. Many Venture Capitalists (VCs)

go for finding a dot-com business, taking them to the public and selling the stocks to

realize quick gains. Because of their desire to make quick money, the VCs often bring

premature companies to public, making investors betting on companies that may lack a

good business model. This GetRichQuick mentality is also apparent in many investors

who often ignore the fundamental values such as the long-term potential of a company and

its past performance. A lack of solid business model also attributes to the formation of

internet bubbles. Almost every dot-com company, when it goes public, has little earnings

and no major revenue stream with certainly no profits. In addition, many of them are

driven by ideas unlike traditional companies with factories that produce products to sell.

One of the main components

of Internet bubbles is

GetRichQuick mentality

that prevailed in the market.


8/11


9/11

9

Puzzlingly, bubbles occur even in highly predictable experimental markets, where

uncertainty is eliminated and market participants should be able to calculate the intrinsic

value of the assets simply by examining the expected stream of dividends. Nevertheless,

bubbles have been observed repeatedly in experimental markets. Experimental bubbles

have proven robust to a variety of conditions, including short-selling, margin buying, and

insider trading. It is not clear what causes bubbles; there is evidence to suggest that they

are not caused by bounded rationality or assumptions about the irrationality of others, as

assumed by greater fool theory.

One possible cause of bubbles is excessive monetary liquidity in the financial system,

inducing lax or inappropriate lending standards by the banks, which asset markets are then

caused to be vulnerable to volatile of those asset forces caused by short-term, leveraged

speculation. When interest rates are going down, investors tend to avoid putting their

money into savings accounts. Instead, investors tend to leverage their capital by borrowing

from banks and invest the leveraged capital in financial assets such as equities and real

estate. Economic bubbles often occur when too much money is chasing too few assets,

causing both good assets and bad assets to appreciate excessively beyond their

fundamentals to unsustainable levels.

Greater fool theory portrays bubbles as driven by the behaviour of incorrigibly optimistic

market participants (the fools) who buy overvalued assets in anticipation of selling those to

other speculators (the greater fools) at much higher prices. According to this unsupported

explanation, the bubbles continue as long as the fools can find greater fools to pay up for

the overvalued asset. The bubbles will end only when the greater fool becomes the greatest

fool who pays the top price for the overvalued asset and can no longer find another buyer

to pay for it at a higher price.

Extrapolation is projecting historical data into the future on the same basis; if prices have

risen at a certain rate in the past, they will continue to rise at that rate forever. The

argument is that investors tend to extrapolate past extraordinary returns on investment of

certain assets into the future, causing them to overbid those risky assets in order to attempt

to continue to capture those same rates of return. Overbidding on certain assets will at

some point result in uneconomic rates of return for investors; only then the asset price

deflation will begin. When investors feel that they are no longer well compensated for


10/11

10

holding those risky assets, they will start to demand higher rates of return on their

investments.

Another related explanation used in behavioural finance lies in herd behaviour, the fact that

investors tend to buy or sell in the direction of the market trend.

Moral hazard is the prospect that a party insulated from risk may behave differently from

the way it would behave if it were fully exposed to the risk. A person's belief that they are

responsible for the consequences of their own actions is an essential aspect of rational

behaviour. An investor must balance the possibility of making a return on their investment

with the risk of making a loss - the risk-return relationship.

SUGGESTION:-

LIFE STYLE WRAP should be the fundamental principle for an investor to invest i.e. life

protection, capital protection and to have a quantitative look towards growth. That is we

can say inflation protection. It is apparent that most bubbles tend to follow discoveries,

technical breakthroughs, or new consumption groups. Historically, the railroad,

automobile, biotechnology, PC, and the Internet boom-and-busts are all examples of

bubbles. Even the Dutch Tulip bubble is a result of a new fashion in arraying fresh tulips

at tops of the womens gowns. In all the asset bubbles we have seen that it is short term in

nature. So according to me, in todays era or we can say in the coming decade, investors

should invest in green fund. Investors should look towards the company who are following

the theory of triple-bottom line. To be very precise, companies who are continuously

striving towards achieving inclusive growth and sustainable development.


11/11

11

BIBLIOGRAPHY

1. Investments by Zvi Bodie ( Boston University), Alex Kane (Univerity ofCalifornia, San Diego) , Alan J. Marcus (Boston College) & Pitabas Mohanty

(XLRI. Jamshedpur)

2. Is Your Bubble About to Burst? By John Tatom Indiana State University - Schoolof Business(October 2005) NFI Working Paper No. 2005-WP-02

3. The Role of the Informational Efficiency in the DotCom Bubble by Wiston AdrinRisso , Department of Economics, University of Siena

4. http://www.springerlink.com/index/nl473x605h24031k.pdf5. http://www.econ.utah.edu/~korkut/Asset%20Price%20Bubbles.pdf6. Bubble Poppers: Monetary Policy and the Myth of Bubbles in Asset Prices by Dr

Stephen Kirchner

7. http://www.princeton.edu/~hhong/float26.pdf8. http://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=

1

9. http://dfm.idaho.gov/Publications/EAB/Forecast/2008/January/Article_0108.pdf
http://www.springerlink.com/index/nl473x605h24031k.pdfhttp://www.springerlink.com/index/nl473x605h24031k.pdfhttp://www.econ.utah.edu/~korkut/Asset%20Price%20Bubbles.pdfhttp://www.econ.utah.edu/~korkut/Asset%20Price%20Bubbles.pdfhttp://www.princeton.edu/~hhong/float26.pdfhttp://www.princeton.edu/~hhong/float26.pdfhttp://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=1http://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=1http://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=1http://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=1http://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=1http://dfm.idaho.gov/Publications/EAB/Forecast/2008/January/Article_0108.pdfhttp://dfm.idaho.gov/Publications/EAB/Forecast/2008/January/Article_0108.pdfhttp://dfm.idaho.gov/Publications/EAB/Forecast/2008/January/Article_0108.pdfhttp://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=1http://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=1http://www.princeton.edu/~hhong/float26.pdfhttp://www.econ.utah.edu/~korkut/Asset%20Price%20Bubbles.pdfhttp://www.springerlink.com/index/nl473x605h24031k.pdf

dealing with asset bubble

Documents