Psychology of a Bubble

I stumbled upon this excellent post on the Irvine Housing Blog.

I suggest reading through when you have a few moments to review some of the important markers of a bubble market, how people rationalize purchasing in a bubble, and how it always ends.

Here is a great quote and some useful visuals:

The efficient markets theory does explain the behavior of asset prices in a typical market, but when price change begins to feedback on itself, behavioral finance is the only theory that explains this phenomenon. There is often a precipitating factor causing the break with the normal pattern and releasing the tether from fundamental valuations. During the Great Housing Bubble, the primary precipitating factor was the lowering of interest rates. The precipitating factor simply acts as a catalyst to get prices moving. Once a directional bias is in place, then price-to-price feedback can take over. The perception of fundamental valuation is based solely on the expectation of future price increases, and the asset is always perceived to be undervalued. There are often brave and foolhardy attempts to justify these valuations and provide a rationalization for irrational behavior. Many witnessing the event assume the “smart money” must know something, and there is a widespread belief prices could not rise so much without a good reason. Herd mentality takes over.