Sunday, July 31, 2011

Boombustology: Chapter 1

Asset bubbles are frequently popping up, and back down. They are easy to spot in hindsight, but we appear to lack the tools to recognize them ahead of time. Vikram Mansharamani aims to rectify that with his book, Boombustology. He applies a multi-lens approach to understanding bubbles with the aim of giving the reader the ability to identify bubbles, and thereby avoid being caught unaware.

Bubbles cannot be understood through traditional tools of financial analysis. A number of factors are interacting with each other that cause markets to fluctuate wildly from fundamentals. Mansharamani therefore advocates a multi-lens approach, to better understand bubbles. Each of the first five chapters covers one of the five lenses through which bubbles may be viewed. In the first chapter, the "micro-economic" lens is explored and described.

Price tends to regulate markets in the micro-economy. When prices are higher than they should be, demand falls and supply increases, helping push prices towards some stable equilibrium state. Most of the time, this mechanism works because of the immense power of supply and demand, or as Adam Smith would call it, the invisible hand.

But there are times when this system breaks down. For example, sometimes higher prices actually invite, rather than quell, demand. To understand this phenomenon, Mansharamani describes George Soros' theory of reflexivity. Under this theory, market observers are not simply observers of events, as their perceptions actually change reality. Reality and perception are constantly engaged in a dynamic, two-way feedback mechanism.

A good example of this phenomenon in action occurs in the real estate industry. The reality may be that an increased willingness to lend is resulting in higher real estate demand, which leads to higher real estate prices. Perception, however, may be that some other reason is causing real estate prices to rise. This perception itself results in higher prices that in turn increase the willingness to lend. What follows is a situation where there is no equilibrium state, as prices start running on a course towards an unknown destination.

Mansharamani concludes that most of the time, the supply/demand equilibrium model works in viewing systems from a micro-economic lens. But there are times when an asset's situation can best be understood from a reflexivity point of view.

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