Bubba bursts the bubble.

An economic bubble signifies a situation when some prices (say, of stocks or houses) rise far above their actual value. Generally, they occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money.

What goes up, eventually comes down.

Nobel laureate Robert Shiller (Economics, 2013), who correctly identified bubbles in tech stocks in the late 1990s and in property in the 2000s, compares a bubble to a mental illness. “It is marked by excessive enthusiasm, participation of the news media, and feelings of regret among people who weren’t in the bubble.”

Sooner or later, however, investors realize how dramatically disconnected they are from economic reality (such as corporate profits or family incomes). And that’s when the fat lady sings. Usually, but not always, this triggers a massive sell-off and sudden collapse of prices as everyone stampedes for the exit.

Most recently, 25 years of prosperity conditioned people—bankers, regulators, economists, almost everyone—to take stable growth for granted. Government affordable-housing policies built an enormous mortgage bubble by 2007—nine times as large as any bubble in modern history. When it popped, housing prices nosedived by 30%-40%. (This sudden collapse of value is called a Minsky moment, named after economist Hyman Minsky.)

A fool is wise in his eyes.

Where do bubbles come from? New research led by behavioral economist Colin Camerer (2014) suggests that bubbles might be caused not by people who lack information, but by those who have too much. “People seem to be buying,” he says, “because they think they can sell to somebody else who isn’t able to control himself as well as they can, or isn’t as prescient as they are (superiority trap*).” In their search for the “greater fool” they can sell to, they fail to realize that they may be the greatest fool of all.

How to avoid Bubba’s bite.

• Analyze the situation critically. Instead of thinking about contingencies, people daydream about their future prosperity. Simply being aware of the larger picture is a good starting point.
• Avoid being overly optimistic. We tend to be extremely optimistic about the future and bubbalicious people believe prosperity will continue forever. It never does.
• Safety in numbers?  Generally, people believe there is safety in the middle of the herd. After all, isn’t everybody recommending and buying it? Sure, while the Pied Piper plays “Hi ho, hi ho, it’s off the cliff we go!”
• Beware of “pseudo-professionals”.  Talking heads generate froth, but their judgment is little better than yours. True professionals will cash out at your expense—you cannot outsmart them.
• Use common sense!  Avoid knee-jerk reactions. Many of us fear looking foolish if we pass up our one great opportunity in a lifetime to get rich quick.
• Get outa Dodge. If everybody else is doing something silly, or you hear the phrase “This time it’s different,” ditch the network and social links that make you susceptible.

Unfortunately, we accept what we see and hear, becoming passive absorbers of information rather than critical listeners or readers. Like wildebeests, we simply moooove with the herd. The crocs will love your for it!

* Questionable beliefs can “trap” our better judgment, leading to poor decisions and unintended consequences. In the superiority trap, we often exaggerate the extent of our knowledge, ability, or memory and overemphasize our sense of control over events. Learn more about this, and other traps, in the Young Person’s Guide to Wisdom, Power, and Life Success.

Image credit: “Popped” by Carterse (2011), licensed under CC BY-SA 2.0.