Introduction
The Tulip Mania that took place between 1636 and 1637 is one of the earliest recorded financial bubbles (Veen, 2012). While there is no universally accepted definition of a financial bubble, the term financial bubble is used to refer to a situation where an asset price exceeds the asset intrinsic value, or the value that could be earned by holding the asset to maturity for an extended period of time (The Federal Reserve Bank of Chicago, 2012). The Tulip Mania fits the description of a financial bubble because at its height, the price of some tulip bulbs exceeded the prices of some luxury homes (Beechy, 2012).
Tulips arrived first in Holland from Turkey during the sixteenth century and became very popular among the wealthy people who would pay high prices for the most stunning tulips (Beechy, 2012). The supply of exotic tulips was limited because tulips bulbs had to grow for a couple of yearends before they bloomed (Beech, 2012). The limited supply of exotic tulips caused their prices to begin to rise. In 1634, a Futures market for trading tulips was established and this enabled people to trade tulip contracts without either growing or owning the tulip (Beech, 2012). After the futures market was established, it was not long before speculators joined the market.
Beech (2012) argues that speculators were motivated by four key factors. One, the growth in the Dutch economy that created new wealth, not just for the elites but also for the middle class who were eager to engage in the tulip trade. Two, a speculation on the Dutch India Company shares had turned out very profitable creating new wealth for speculators and giving them new confidence to take out more speculative positions (Beech, 2012). Three, the tulip trade was uncontrolled and thus anybody interested in the trade could easily enter the tulip trade (Beech, 2012). Four, the Bank of Amsterdam policy on free coinage, encouraged capital flows to Holland that improved the liquidity of the financial markets (Beech, 2012). These four factors fuelled a rapid rise in the prices of tulips. At around October 1636, the prices of tulips rose rapidly reaching a peak in February 1637 before the market crashed (Beech, 2012).
Preconditions for a bubble
Jiménez (2011) argues that for a bubble to occur, four factors must be fulfilled. The first precondition to any bubble is a rapid rise in asset prices. A bubble will exist where asset prices rise rapidly and there is a big divergence between the asset prices and its fundamental value such that sooner or later the will be a drastic correction of the price that might result into a crash (Jiménez, 2011). Second, there must be excessive speculation on the asset prices driven largely by investor’s zeal who believe that asset prices will keep rising in the future. Three, there must be a prominent venture, ‘a once in a lifetime’ kind of investment but which the success of the venture is uncertain (Jiménez, 2011). Four, the participants must have used some leverage, meaning that they exposed themselves to a much bigger position by using debt (Jiménez, 2011).
The tulip mania satisfied all these conditions. The tulip prices rose dramatically driven by speculators excitement about future prices rather than fundamental attributes of the tulips or an increase in the cost of production. The fact that the trade in tulips was uncontrolled, it allowed anyone who was interested in speculating to speculate on the tulips. The tulips were a venture whose fortunes were uncertain, and many people thought that it would be wildly successful earning them huge profits. The availability of futures, allowed traders to enter into leveraged positions at much lower capital outlay. Investors would just put deposits for tulips contracts and hoped to make capital gains when they sold it later at a much higher price (Pettinger, 2013).
Behavioral characteristics that give rise to a bubble
The efficient market hypothesis (EMH) postulates that investors as a whole are rational that is, while some investors may be overly optimistic about future price increases, others will be pessimistic and this will even out the irrationality in the price (Beech, 2012). The EMH therefore, argues that in an efficient market the price of an asset will always be equal to its intrinsic value. According to EMH bubbles in asset prices should not occur as investors will act rationally. However in reality, bubbles in asset prices indicate that investors are not always rational. The Behavioral finance notes several behavioral biases that try to explain some of the investor’s irrationality.
Anchoring bias refers to the tendency of investors basing their decision on a reference point (anchor) that may not have a logical relevance (Forbes, 2009). An investor could have anchored their decision to buy more tulips on the last price they paid rather than try and estimate the intrinsic value of the tulips. If they found the price had gone down slightly they would view such a price drop as an opportunity to buy more tulips at a bargain which they can sell later at a much higher price.
Representativeness bias refers to the tendency of investors to over rely on the most recent information (Montier, 2013). In the case of the tulips mania, investors may have observed the rising prices of tulips and falsely concluded that tulip prices will always go up. This would have given investors an incentive to invest in the tulips with expectations that their prices will continue rising.
Herd mentality refers to the tendency of individual to imitate the behaviors of a larger group even though they might behave differently if they were alone (Forbes, 2009). Herd mentality arises due to the need for individuals to conform, and the thinking that such a large group of people cannot possibly be wrong. In the tulip mania, individuals may have been motivated to buy the tulips at inflated prices when they observed others buying. Herd behavior is more common in situations where individuals are uncertain about the prospects of a particular venture and looks up to others for guidance.
Belief perseverance occurs when investors hold to their beliefs about their investment strategy even in the light of new information that contradicts the investment strategy (Montier, 2013). In the tulips mania, investors persisted in buying the tulips at higher prices despite the supply of tulips having increased. An increase in the supply of the tulips would have put downward pressure on the market and brought the market to equilibrium instead of crashing.
Overconfidence bias refers to the tendency of investors having an exaggerated opinion about their abilities to select the right assets, making the right judgment as to when to enter or exit a market (Montier, 2013). In the tulip mania, investors with overconfidence bias may have overestimated their ability to select the best types of tulips to invest in, when to enter into various trades and so on. Investors suffering from overconfidence bias tend to trade more excessively than the average trader.
Confirmation bias refers to the investor’s tendency to search or recall information that reinforces their preexisting beliefs while discounting information that may contradict that may contradict their preexisting beliefs (Forbes, 2009). In the tulips mania, investors may have ignored signs that the rise in tulips prices was irrational. Instead the investors may have only searched and interpreted information about tulips in a way that reinforced their belief that tulip prices would keep rising.
Consequences of rising and bursting bubble
When a bubble burst its effects can be classified into wealth effects, unemployment effects and policy effects (Beech, 2012). Investors suffer huge losses in wealth as the price of their assets tumble. Some households lose their life savings and a significant portion of their wealth leading to lower expenditure in the economy resulting into lower aggregate demand, layoffs and further loss of income (Beech, 2012).
When there is a financial crisis arising from a bubble burst, businesses find it difficult or expensive to borrow loans to finance capital expenditure or purchase inputs too keep production at full capacity. Low output translates into lower profitability. Furthermore, the fall in aggregate demand forces businesses to lay off workers causing a rise in unemployment. There will be significant high costs, frictions, and loss of productivity in redeploying workers in the collapsed sector to other sectors. The increased unemployment lowers the government tax revenues and reduces the aggregate demand forcing the economy into a recession (Tanzi, 2013).
In most cases, the ensuing recession from the bursting of a bubble force most governments to formulate polices to get the economy out of a recession. The stimulus policies include a set of fiscal and monetary policies that are aimed at increasing aggregate demand and growing the economy (Tanzi, 2013). Governments adopt expansionary monetary policies that reduce the cost of credit giving people an incentive to borrow and spend. On the other hand, the fiscal policies include government using a combination of taxes and subsidies to increase aggregate demand. In some cases the government is forced to bailout some market players to avoid wide spread economic crisis (Pettinger, 2013).
In the tulips mania investors suffered significant losses, those who had used leverage to buy the tulips found themselves heavily indebted after the tulip prices crashed (Pettinger, 2013). The collapse in the market could have made investors more risk averse resulting in lower investment spending and a fall in the aggregate demand forcing the economy into a recession.
How to detect bubbles
Detecting the formation of a bubble is important in order to promote financial stability. However, in practice it is difficult to distinguish between asset prices that increase due to rational factors, and asset price increases that are driven by market exuberance (Kubicova, 2011). In other words, it is important to distinguish between a bull market where asset prices are appreciating and the formation of a bubble where the asset price significantly deviates from the asset intrinsic value and will have an abrupt correction resulting in massive losses (Davies, 2014).
Kubicova (2011) argues that one can predict the formation of a bubble by using three statistical methods, trend curves and price ratios as statistical filters. The trend curve involves using time series data to identify the trend in a particular asset prices and comparing the current prices to the trend and noting of any significant deviations. The problem with the use of the trend curve is that one must have access to data over long periods of time which may not be available in emerging and developing countries.
Price ratios such as price/earnings ratios and price/income ratios can be used to filter the existence of a bubble in an asset. For an asset like an ordinary share its price would be influenced by fundamental factors such as expected dividend or earnings. Since the information about the prospects of a company arrive in the market gradually it is logical to expect that the share price will change steadily. There should be a correlation between changes in the fundamentals and changes in the stock price. An explosive deviation of the asset price from known price/earnings ratios or price/income ratios may indicate the existence of a bubble (Davies, 2014). Constructing confidence levels can help establish the limits when arise in asset prices will be considered as a bubble. The most commonly used levels of confidence are 90%, 95%, and 99%.
Conclusion
Asset bubbles are said exist whenever the price of an asset far exceeds the intrinsic value of the asset. The tulips mania is one of the earliest recorded cases of asset bubbles. For a bubble to come into existence there must be a rapid rise in asset prices to a point where market values deviate significantly from the asset’s intrinsic value. There must be excessive speculation that further misalign asset prices form their intrinsic values. There must be a worthy venture that a critical mass wants to enter. For instance, the belief that owning a home is every American dream contributed to the recent housing bubble. Lastly, participants must have used leverage and thus magnifying their exposure.
EMH argues that investors are rational and consequently bubbles cannot exist. But behavioral finance argues that investors are not always rational because they sometimes suffer from behavioral biases that make them to be irrational. The fact that bubbles keep reoccurring suggest that investors continue to suffer from behavioral biases in making investment decisions. Bursting of bubbles result in the loss of investors’ wealth, rise in unemployment, and prompt governments to develop polices to get the economy out of the recession that follows a bubble burst.
Identifying bubbles is difficult because not every bull market is evidence of an existence of a bubble. A bubble will only be said to exist if the price of the asset deviates significantly from known fundamentals. Statistical techniques such as trend curves and use or price/earnings ratios or price/income ratios can form useful benchmarks against which to judge whether asset prices have deviated significantly and thus suggest the existence of a bubble.
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