One thought on “If people are indeed rational, as you say, then how can bubbles arise and persist for so long?”

  1. Briefly: Asset Bubbles arise because the flow of negative information into the market is cut off. This is often because short selling is prevented.

    Longer Answer:

    Every day, there are investors who go long and short on a particular stock. Those who go long are betting that the stock is undervalued, while those who short are betting that the stock is overvalued. Every time someone goes long, they are increasing the demand for the stock. Every time someone goes short, they are increasing its supply. So, the price at any time is simply the average of the opinions between those who are holding long and short positions on the same stock.

    Now, imagine for a moment that a group of investors are combining their money and targeting one company by all taking short positions on that firm. This will cause the price of that firm’s stock to drop. If people are rational, which is a questionable assumption in itself, then no one should panic. After all, the intrinsic value of the company is still the same and noting has changed in its fundamental business. However, everyone knows that there is always hidden information in the market. The problem is that when a rational person sees the price of a firm’s stock dropping, they assume that someone in the market knows negative information about that firm that they don’t. In order to cut short their losses, even the most rational investors will be inclined to sell their stock. This causes a self fulfilling prophecy and the price of the stock truly plummets, giving huge returns for those who have taken the short position.

    When these sort of short position attacks happen a lot, the regulators are forced to ban short selling to maintain market confidence. However, such a move comes with an obvious disadvantage; now the flow of negative opinion into the market has been reduced. This means that there are more investors taking long positions compared to short ones, thus artificially inflating the price of the stock. When short selling is banned across the market, this happens to all assets, leading to a bubble.

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