more game theory and bubbles

http://www.theatlantic.com/doc/print/200812/financial-bubbles
"Pop Psychology"
by Virginia Postrel
December 2008
The Atlantic

More on the subject of a previous post. The article discusses lab research into the behavior of markets where there is absolutely no uncertainty about the risks and returns on certain securities: in other words, where the fundamental worth is exactly known by everyone. And yet bubbles still happen. This is because, the author states, each person doesn't know that everyone knows that everyone is rational. The very possibility of irrational actors, even if there aren't any, can result in bubbles (remember your Hobbes!). The author writes:

"Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But—here’s the wrinkle—you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit."

And once I am willing to pay 3.25, that starts to drive the price upwards - creating all the more reason to buy the items at prices above their fundamental worth - which drives prices up further.

Another interesting aspect of the article is that it argues that there are two characteristic investment strategies: speculation and momentum. Speculators rush in at the beginning and buy as much as they can. Then they get out during the bubble. Momentum investors (so-called because they follow the market's momentum), on the other hand, start off rational: they know the fundamental value, and aren't willing to pay too much for it. But then the market starts to go up, and they realize that it's reasonable to start buying (unfortunately, prices have already risen, so they buy less than speculators). And, of course, eventually the speculators get out and the momentum buyers run out of cash to drive further price increases - and the market crashes. And momentum buyers all try to sell! And of course they get screwed and the speculators make a killing (an $80 difference).

What is interesting about this is that the momentum strategy looks like a reasonable, rational course to pursue. And the speculation strategy looks weird - buying the items for more than they're clearly worth, then selling them while their prices are still increasing. But the speculators have it right! (At least in this instance).