This Paper works out how psychological approaches can be applied on financial bubbles. The thesis shows that it is impossible to explain financial bubbles clearly and without flaws with classical rationality and perfect markets. Furthermore this paper tries to unite various behavioral approaches to explain financial bubbles in a more realistic way. Financial bubbles imagine a great importance for the entire economy, caused by their strong economic impact. Therefore an understanding of these bubbles is crucial to counteract them. To gain the aspired results the paper will present empirical studies and inconsistencies in classic economic theory. Additionally it will adjust alternative behavioral models for financial bubbles. It will be shown how human behavior leads to inherent mistakes at financial markets, which cause financial bubbles.
Diese Arbeit beschäftigt sich mit der Anwendung von psychologischen Verhaltensmodellen auf Finanzmärkte zur Erklärung von Finanzblasen. Es wird verdeutlicht werden, dass aus der klassischen Ökonomie stammende Theorien nicht in der Lage sind Finanzblasen fehlerfrei und eindeutig zu erklären. Daher bedient diese Arbeit sich psychologischer Modelle um Finanzblasen realitätsnäher zu erklären. Durch ihre immense Wirkungskraft beeinflussen Finanzblasen die gesamte Wirtschaft.
Deswegen ist es außerordentlich wichtig diese zu verstehen um rechtzeitig Kontrollmaßnahmen einzuleiten. Um die angestrebten Resultate zu erreichen bedient sich diese Arbeit mehrerer empirischer Studien sowie Unregelmäßigkeiten in der klassisch ökonomischen Theorie. Weiterhin werden psychologische Modelle in einem einheitlichen Erklärungsmodell angepasst werden um Finanzblasen zu erklären. Dieses Modell wird verdeutlichen, dass es in der menschlichen Natur liegt Fehler zu machen. Diese Fehler führen auf den Finanzmärkten zu Finanzblasen.
Table of Contents
1 INTRODUCTION
1.1 Task of the Paper
1.2 Methodology
2 FOUNDATIONS OF BUBBLE RESEARCH
2.1 Understanding Bubbles – A Crucial Point
2.1.1 Locusts and Financial Bubbles
2.1.2 Feedback cycles of financial markets
2.2 Bubbles in a historical Perspective
3 RATIONAL BUBBLES WITH CONVENTIONAL RATIONALITY AND PERFECT MARKETS
3.1 Perfect Financial Markets
3.1.1 Present Value Model
3.1.2 Efficient Market Hypothesis
3.2 Classical Rational Behavior under Risk and Uncertainty
3.2.1 Axioms of the EUM
3.2.2 Expected Utility and von Neumann – Morgenstern Utility Function
3.3 Rational Bubbles
3.3.1 Rational Expectations and Identical Information
3.3.2 Asymmetric Information
3.4 Anomalies and Deviations of the EUM
3.4.1 The Allais Paradox
3.4.2 The Disposition Effect
3.5 Conclusions for the Classical Model in Bubble Research
3.5.1 Imperfect Markets
3.5.2 Consequences for Rationality
4 THE DEVIATION FACTOR HYPOTHESIS
4.1 Bounded Rationality adjusted for Financial Bubbles
4.1.1 Non – optimal Decision Making
4.1.2 Detection of Decision Mistakes
4.2 Inherent Decision Mistakes
4.3 Exceeded Non - Rational Behavior
4.3.1 Over - Confidence and Euphoria
4.3.2 Fear
4.4 Indicators for Non - Rational Behavior and Difficulties in Observation
4.4.1 Leading Indicators of Confidence
4.4.2 Indices in Appliance and Limits of Measurement
5 CRITICAL ACCLAIM
5.1 Bubble- and Crisis Research
5.2 Psychological Approaches
5.3 Critique on the Deviation Factor Hypothesis
6 CONCLUSION
Research Objectives and Core Topics
This thesis investigates the formation and progression of financial bubbles by integrating classical economic theory with behavioral and psychological perspectives. It aims to answer whether the process of financial bubbles, from initiation to collapse, can be explained through indicators derived from psychological theories, specifically addressing why classical rational models fail to fully capture these phenomena.
- Application of psychological behavioral models to explain market irrationality.
- Limitations of classical economic theory, such as the Expected Utility Model (EUM) and Efficient Market Hypothesis (EMH).
- The role of "Bounded Rationality" and "Information Asymmetries" in market decision-making.
- Development of the "Deviation Factor Hypothesis" as a conceptual framework for bubble dynamics.
- The psychological drivers of bubbles: Over-confidence, euphoria, fear, and confidence multipliers.
Excerpt from the Book
4.1.1 Non – optimal Decision Making
If a DM is confronted with a problem with time scarcity, where he must make a decision he can either face a familiar or an unfamiliar problem. He always tries to make the optimal decision In case of a familiar problem the DM applies a proven strategy or method to solve it. If he faces an unfamiliar problem it is different. At first he does not know which strategy to apply. Hence he searches for an optimal strategy. During this process he faces further problems where he must make optimal decisions. They also must be solved. Therefore he keeps on searching for methods. Thus if a decision maker must make an optimal decision for an unfamiliar problem he finds himself in an infinite line of problems and strategies, where each problem or strategy is a result of the previous problem or strategy. Hence optimization with time scarcity is not possible when DMs are confronted with unfamiliar problems. Unfortunately DMs are often confronted with unfamiliar problems in the real world.
Summary of Chapters
1 INTRODUCTION: Presents the motivation for studying financial bubbles, using Goethe's Faust as an analogy, and defines the research question regarding the psychological indicators of bubbles.
2 FOUNDATIONS OF BUBBLE RESEARCH: Establishes the relevance of financial bubbles for the economy and introduces feedback cycles, such as the wealth effect and confidence effects, as drivers of market instability.
3 RATIONAL BUBBLES WITH CONVENTIONAL RATIONALITY AND PERFECT MARKETS: Critically evaluates the Present Value Model and the Efficient Market Hypothesis, highlighting their inability to explain empirical market anomalies like the Allais Paradox.
4 THE DEVIATION FACTOR HYPOTHESIS: Introduces a new explanatory framework that incorporates Bounded Rationality, confidence, and fear to explain market behavior that deviates from classical rational expectations.
5 CRITICAL ACCLAIM: Discusses existing critiques of crisis research and behavioral economics, positioning the thesis's proposed hypothesis within the broader scientific discourse.
6 CONCLUSION: Synthesizes the main arguments, confirming that psychological approaches provide a more accurate explanation of bubble dynamics than traditional models, despite the challenges in empirical measurement.
Keywords
Financial bubbles, Behavioral economics, Bounded rationality, Expected utility model, Efficient market hypothesis, Information asymmetry, Cognitive dissonance, Aspiration adaption theory, Confidence multiplier, Market irrationality, Prospect theory, Over-confidence, Euphoria, Decision heuristics, Financial crises
Frequently Asked Questions
What is the primary focus of this research?
The thesis explores how psychological behavioral models can better explain the development and eventual collapse of financial bubbles compared to traditional, strictly rational economic theories.
Which core concepts are central to this work?
The study centers on Bounded Rationality, Information Asymmetry, the "Deviation Factor Hypothesis," and the impact of human emotions such as confidence, euphoria, and fear on asset pricing.
What is the main objective of this study?
The primary goal is to determine if the process of a financial bubble can be explained by psychological indicators and to propose a framework that bridges the gap between theory and observed market behavior.
Which scientific methodology is employed?
The author uses a comparative approach, contrasting classical economic models (like the EUM) with behavioral insights to identify flaws in traditional models and synthesize a more realistic, albeit speculative, explanatory framework.
What is discussed in the main body of the work?
The main body examines the foundations of bubble research, critiques the shortcomings of perfect market assumptions, presents the "Deviation Factor Hypothesis," and analyzes how heuristics and biases drive non-rational behavior.
How is the thesis characterized by its keywords?
The work is defined by terms like "Financial Bubbles," "Bounded Rationality," "Behavioral Economics," and "Confidence Multiplier," reflecting its focus on the intersection of human psychology and financial market volatility.
What is the "Deviation Factor Hypothesis"?
It is a proposed descriptive framework that categorizes various psychological drivers (such as bounded rationality and confidence) as variables that cause market prices to deviate from their fundamental values.
Why does the author argue against the "rational investor" myth?
The author argues that the "rational investor" model fails to account for real-world phenomena like the Allais Paradox and the Disposition Effect, making it insufficient for explaining the systemic nature of financial crashes.
What role does Cognitive Dissonance play in the author's argument?
Cognitive Dissonance is identified as the reason why economic agents often fail to detect or correct their own decision mistakes, thereby allowing bubbles to grow unchecked.
- Quote paper
- Michael Gebauer (Author), 2013, Psychological Approaches applied on Financial Markets, Munich, GRIN Verlag, https://www.grin.com/document/274594
