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The Origins of Collective Overvaluation: Irrational exuberance emerges from simple, honest and rational individual behavior

The Origins of Collective Overvaluation: Irrational exuberance emerges from simple, honest and rational individual behavior Michael L. Anderson (michael.anderson@fandm.edu) Department of Psychology, Franklin & Marshall College Lancaster, PA 17604 USA C. Athena Aktipis (aktipis@alumni.reed.edu) Department of Ecology and Evolutionary Biology, University of Arizona Tucson, AZ 85721 USA Abstract The generation of value bubbles is an inherently psychological and social process, where information sharing and individual decisions can affect representations of value. Bubbles occur in many domains, from the stock market, to the runway, to the laboratories of science. Here we seek to understand how psychological and social processes lead representations (i.e., expectations) of value to become divorced from the inherent value, using asset bubbles as an example. Using an agent-based model we explore whether a simple switching rule can generate irrational exuberance, and systematically explore how communication between decision makers influences the speed and intensity of overvaluation. We show that rational and simple individual level rules combined with honest information sharing are sufficient to generate the collective overvaluation characteristic of irrational exuberance. Further, our results demonstrate that simple noise in the exchange of value information leads to rapidly increasing expectations about value, even when no one is engaged in exaggerating their expectations for the assets they own. Keywords: decision making; modeling; rationality; emergence. valuation; agent-based Introduction Chances are, your savings are invested in one or more kinds of assets—stocks, bonds, real estate, etc. Moreover, if you are an individual investor, or are planning on becoming one soon, you probably discuss the markets with various other investors, including friends, family, colleagues and investment professionals. You might also listen to one of the many market watch programs, or read the business section of your daily newspaper. In short, you are probably engaged in both soliciting and offering opinions on how various market sectors will perform in the future. Once in a while, this information will cause you to make a change in your portfolio. Imagine, for instance, that someone you trust shares with you their expectation for the performance of one of their investments. Imagine further that this expectation exceeds the expectation that you yourself have for your own investments. Surely there is some chance that you would sell (some of) your own portfolio, and invest in the asset with the higher expected return. Whether you would do this naturally depends on myriad other factors— your tolerance for risk, the perceived balance of your current investments, the liquidity of this new asset class, etc. But there remains some chance that you will make the switch. This is natural, and even—assuming that one of your financial goals is to maximize return consistent with other priorities—rational. But if we are right, this natural, rational behavior is sufficient to spark irrational exuberance. Asset bubbles are among the most fascinating and puzzling phenomena in economic markets. Decision makers frequently drive up prices and demand to levels that seem completely divorced from the underlying value. Bubbles are common, and far from innocuous. Post-bubble market “corrections” have led to financial ruin for many, as occurred in the great depression and in the current real estate and financial crises. And there seem to be some important similarities between asset bubbles and other sorts of collective behavior, including clothing fashions, popular music trends and perhaps even the trajectory of science (with processes such as paper acceptances and grant funding being based on the expectations of reviewers about the future value of the work). Thus, bubbles are important to understand, to say the least. In the current paper, rather than seeking to understand these events through analyzing or modeling the complex historical and economic factors that lead to a specific instance of collective overvaluation, we have instead focused on formulating some simple and general individual rules that we hypothesize are sufficient to generate the phenomenon of irrational exuberance. We have isolated what we believe to be a key underlying cause of collective overvaluation / irrational exuberance across many contexts, and have constructed a simple model to explore whether it generates the predicted outcomes. Here we model the genesis of collective overvaluation as a general phenomenon, using decision making about asset classes as an example. We aim to make this model as general as possible, making it potentially applicable to other domains. Model Description The model description offered below follows the standardized ODD protocol for describing individual and agent based models (Grimm and Railsback 2005; Grimm et al. 2006). This protocol for describing agent based models has been developed with input from modelers across the disciplines and is in wide use.