Proprietary Trading Systems for Stocks, Futures, Currencies, ETFs, LEAPS & Commodities
Michael Covel's Trend Following Research, Training, Books & Documentary Film

Learn How Now

Trend Commandments

Michael Covel (FT Press)

Purchase | Reviews

The Little Book of Trading

Michael Covel (Wiley)

Purchase | Reviews

The Complete TurtleTrader

Michael Covel (Collins)

Purchase | Reviews

Trend Following

Michael Covel (FT Press)

Purchase | Reviews

Broke (Film DVD)

Michael Covel

Purchase | Reviews

Nobel Prize Winner Vernon Smith on Bubbles

Nobel Prize winner Dr. Vernon Smith is in my film Broke. I Interviewed him in his office in Arlington, Virginia. Today, reading a piece of research (PDF) by James Montier, Dr. Smith’s name popped up. An excerpt:

As long time readers may recall, I am a fan of the use of experimental markets to explore the dynamics of markets. The advantage of the lab is, of course, that information can be fully controlled in a way that just isn’t possible in the real world. The major authority within this sphere is Vernon Smith (joint winner of the Nobel Prize for economics in 2002). In a recent paper Smith and his co-authors explore some issues that may have lessons for the current juncture. They start by setting up an experimental market in which investors can trade an equity with a dividend payment each period. The actual payment is uncertain, but participants are told that there are four states of the world, and all are equally likely, and they are given the payouts that correspond to the various states of the world. Calculating fundamental value is therefore a trivial task of multiplying the probabilities by the payouts, and then multiplying that answer by the number of periods left in the game. (e.g. in round 1 of 15, fundamental value = 24×15 = 360). The chart below shows the path of fundamental value (slopping down from left to right as a dividend is paid out each period), plus the results from two games where participants trade this asset. In their first encounter with this asset, participants start off by enormously undervaluing the asset, trading at an 80% discount to fundamental value in the first few periods. However, as the game progresses, a huge bubble is created. Prices that are 3 or 4 times fundamental value are not uncommon! Eventually the bubble deflates towards the end of the game. The time series generated by this run is labeled inexperienced in the chart below. The same participants are then invited to return to the same market and try trading the asset a second time. Far from learning from their experience in the first round, participants generally go on to create yet another bubble! This time the bubble occurred earlier in the game, and wasn’t quite so pronounced as in the first game (with peak prices being around twice fundamental value!). When asked why the participants created a second bubble, the most common response was they thought they could get out before the top this time! The only tried and tested method of removing bubbles from such markets is to use players who are experienced twice over. The third time they play, you end up with a much tighter correlation between the market price and fundamental value. As Smith says “Once a group experiences trading a bubble and a crash over two experiments and then returns for a third experiment, trading departs little from fundamental value.”

Interesting…

In interviewing Dr. Smith for my film, I recall that my first question, a softball, resulted in a 37 minute answer! Yes, Nobel Prize winners think in great detail!

Note: No vulgarity or ugly attacks. There are other places for that.

  • http://michaelcovel.com Michael Covel

    Does this mean I am predicting a crash? No, I am simply passing along data from a Nobel Prize winner who spent his life studying market behavior (read: sheep!).

  • http://www.investorwalk.com/investorwalk/paul-castro.html Paul Castro

    Interesting stuff. Seems to go a long way toward explaining why stock bubbles are generation-spanning events. By the time a new bubble starts forming (see Internet stock bubble) all the players who were around for the last bubble (see Nifty Fifty) have either died off or retired. Will be fun to watch how soon the next stock bubble forms. Given the increase in human longevity between 1970 and 2000 I may never get to see it especially if my generation has to die off first since I don’t plan on ever retiring from trading.

  • http://michaelcovel.com Michael Covel

    Good point. Everyone from the first bubble or two period needs to die off…and then a new round of generational hubris…repeats the process all over again.

  • carlos

    we constantly need new inexperienced ‘traders’ to come in the market all the time… more bubbles more profit.

  • DG Dye

    This may also explain why most successful traders and investors experience losses when they start trading, often losing everything before they begin their successful run. Notable exceptions tend to be those who have a mentor who implements tight trading parameters at the outset…In other words, someone with experience who has no doubt seen his own losses.

    I wonder how many people give up after two rounds of losses in real-world trading, not realizing they’re on the verge of success? My guess is, the majority of average would-be traders.


Trend Following

Learn trend following now with our firm.

Trading Systems Courses

Books & Film

Trend Following

Trend Following Live

Extras

 

Market Wizard Interviews


  • Jim Rogers with Michael Covel in Singapore.

  • Market Wizard Larry Hite discusses odds.

  • Harry Markowitz on Jim Cramer.

  • Trader Salem Abraham about the unexpected.

  • Michael Covel: Reason TV Interview.

  • Michael Covel in Brazil for BM&FBovespa.

Switch to our mobile site