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Thursday, April 28, 2005

Bubbles and Economists

Why do bubbles exist? If markets are efficient (and frictionless), they shouldn't. In this case, if investors perceive an overvaluation, they'd short the stock and drive its price back to fundamentally sound levels. And yet, bubbles exist.

This NYT article, "Economists Try To Explain Why Bubbles Happen" gives a pretty good explanation for some of the major theories why we have bubbles:
  • The reluctance of sophisticated investors (like mutual funds) to short sell for fear of offending clients
  • The willingness to buy into a bubble if you think the bubble is going to continue to grow for a while. This is also known in real estate as the "greater fool" approach (you don't mind buying an overpriced asset if you can find an even bigger fool to sell it to in the future).
  • Regulatory frictions
It closes with some analysis of hedge fund transactions during the recent tech stock bubble.

Click here for the whole article.

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