Are market bubbles inevitable? Virginia Postrel has an interesting column in The Atlantic that explores the topic and pretty much arrives at that conclusion. Lab experiments run by the Nobel Prize winning economist Vernon Smith have repeatedly shown the formation of market bubbles. But as traders gain experience the bubbles become less likely and eventually disappear. So it appears that experience can have a modifying effect on bubble formation. However, when market conditions change, even experienced traders stumble and bubbles form.
There are two practical implications of this research. One is that markets where too much cash is chasing too few good deals are dangerous and will eventually collapse. Interestingly, traders actually know this and still try to get in with the hope of cashing out before the inevitable bursting of the bubble. The other implication is that big changes in the environment can remove the expertise from experienced traders turning them into novices and making them susceptible to mistakes.
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