The Big Mo!

In the 1960s, a new term crept into sports reporting in the United States.  This term came to describe the extra energy a team would show when they were 'in the zone'.  They were said to have the driving force of momentum on their side - "The Big Mo"



It didn't take long for this term to catch on and it has since come to be used in all sorts of different contexts including political campaigns, social upheavals and economic cycles as well as (you guessed it!) financial bubbles.

Perhaps most notably, the term was used by Mark Roeder (a former UBS Bank exec.) in 2010 when he stated that "The Big Mo" played a pivotal role in the 2008 global financial crisis:

"...recent technological advances, such as computer-driven trading programs, together with the increasingly interconnected nature of markets, has magnified the momentum effect."



Similarly, The Economist published an article entitled "The Big Mo" (available here) which discusses how momentum in markets might explain financial bubbles and contravene efficient markets hypothesis.

Whilst contributions to the concept of momentum are numerous, the best known interpretation is Sir Isaac Newton's Second Law of Motion, which takes the form:

                                                                              F = ma

where F is the force, m is mass and a is acceleration.

The intuition here is that as mass or acceleration (or both) increases, the greater the force.  That is to say, if an object is bigger, or moving with a greater acceleration, stopping it will require greater force.



In 1982, psychologists John Nevin, Charlotte Mandel and Jean Atak, wrote a paper called "The Analysis of Behavioural Momentum", in which they explored why certain behaviours can become persistent over time.  They developed a method of applying Newton's equation to human behaviour and the way we resist change.



Could this be applied to financial markets?  What if the object (F) is the force with which traders hold a certain belief e.g. the housing market is the most profitable and the least risky market.  The mass (m) could be the number of traders and the acceleration (a) the rate of trades taking place.  As more and more traders come around to thinking this way, the asset price soars but so does F.  That is to say, if an idea already has momentum amongst traders, it will take a lot of convincing to change their minds depending on how many of them there are and how much trading they're doing.



If this is in fact the case, the next logical question is what causes the idea to spread in the first place?

Greater Fools and Beauty Contests

"Who's the more foolish, the fool, or the fool who follows him"

Star Wars fans may recognise these words as the ones uttered by Sir Alec Guinness in his role as Obi-Wan (Ben) Kenobi in Episode IV: A New Hope.  This thought-provoking concept forms the basis of one of the earliest attempts to explain financial bubbles in terms of social psychology - greater fool theory.

The idea here is that an investor (the fool) will pay for an asset, knowing full-well that the price is too high.  However, he has confidence in being able to sell it on at a later date, at an even higher price, to another investor (the greater fool).  Although popular among laymen, the theory lacks any empirical clout.




A similar concept is that of the Keynesian beauty contest. 

The idea is to imagine a competition where you are asked to pick the six most beautiful women from a larger pool.  If you pick the 6 most popular women, as decided by every entrant in the competition, you win a prize.





Keynes noted that there are different orders of strategy to selection:

Order 1) 
Pick the women that you find to be most beautiful

Order 2) 
Pick the women that you think other people will find to be most beautiful

Order 3) 
Pick the women that you think other people will think other people will find to be most beautiful

(eh???)

In otherwords, in the third order, you assume that everyone else is chosing based on what they think the average will be i.e. they will selecting using the second order rather than the first.  In the same way, the fourth order would assume that everyone else is thinking in the third order and so on. 

Keynes believed that the same principal applied to financial markets, whereby traders valued prices at the level they preceived to be the average opinion, rather than what they thought was the actual, intrinsic value.

Both of these theories seem to imply that dealer behaviour is not always consistent, leaving room for speculation and the inflation of a bubble.

Money Doesn't Grow on Trees

A simple statement that everyone in Northern Ireland will be aware of, having most likely received it in the form of a mildly agitated response from a parent after a request for money, usually as a child (or perhaps not!).  As a consequence, I think that it would be fair to say that the vast majority of those in today's society would accept the notion that money doesn't grow on trees, you can't get something for nothing and if it sounds too good to be true, it normally is.



It seems that all of these notions were set to one side for a short while in late 2001 as a 'money tree' fad swept across Counties Antrim and Down.  Being from that part of the world myself, I remember this episode quite well and recall wondering how it worked as it seemed to fly in the face of all those clichés I mentioned in the previous paragraph.  For anyone not familiar with the story, I'll break it down using the diagram below:

Here we have JB.  JB has worked his way up to the top level of the money tree since his friends MD and AP, who form the next level down,  have managed to invite two friends each, who form the next level; in this case, JC, TS, GS and RP.  Once everyone in this tier has found two friends to join in, the system begins to pay out. 

 

In the case above we have TH and KP already in this tier.  Once six other investors pay the £3,000 entry fee, JB receives all eight entry fees, walking away with £24,000 - an incredible 700% in profits!  Each member in the tree then moves up a level; MD and AP move to the top level and continue the recruitment process until each person on the bottom level brings in two friends - that's sixteen more people, therefore £48,000 split between MD and AP, so they also leave with their 700% profit and so the process continues.  So long as people keep joining the tree, investors keep progressing up the levels and eventually reach payout - SIMPLES! 

Except it's not that simple is it? As with pricing bubbles, as soon as supply outweighs demand, problems occur. And this is what happened in Northern Ireland. Eventually, people ran out of friends and family to approach and the process of recruiting for the next level stalled and the system failed.  (Either that or people lost the belief that they would make it to the top tier.)  Anyone sitting on the tree lost their £3,000 and as the whole operation was conducted in pubs and restaurants, with each investment classed as a 'gift', there was nothing they could do about it.  Ouch!

More details of this story can be found in the BBC archives: http://news.bbc.co.uk/1/hi/northern_ireland/1647715.stm



Relating back to the title of this post, if people are generally smart and know that money doesn't grow on trees, they must know that a scheme like this is destined for failure, just as traders must know that the price of houses or the value of dot-com businesses can't keep rising forever!  Yet these things keep happening and people, companies and even countries still end up on the verge of financial ruin as a result of the bursting bubble.  I believe that the social sciences can offer (at the very least a partial) explanation for why this is.

An Introductory Overview

As bubbles don't have a unanimously accepted explanation within the world of finance, economist opinion varies quite a bit. Schools of thought range from denial of their very existence to debates about whether or not bubbles are rational. Furthermore, others look to the social sciences to explain pricing bubbles in terms of human psychology and behaviour; and it is this particular area that I find most intriguing.

As a person with something of a casual interest in areas such as epidemiology and evolutionary psychology, I'm interested to see how some of the ideas discussed in books on my bookshelf at home might apply to this particular area of finance. Over the next few weeks I'll take a look at well discussed aspects like greater fool theory and herding, as well as ideas that maybe aren’t quite so well renowned within economics; risk perception, social proofs and the role of context. 



Each of these will shed a little light on issues like why bubbles start, when/why they burst, when they are likely to occur in the first place and why we are destined to see the same newspaper headlines reporting the occurrence of this destructive phenomenon in the future.