I just finished listening to interviews with Eugene Fama and Robert Schiller by Sweden's SVT. Eugene Fama believes in rational economic participants and efficient markets. Accordingly, individual investors can neither outperform the market nor predict asset bubbles. Robert Shiller, who has also done extensive work on asset prices most notably the construction of the Case-Shiller home price index, believes in economic participants who sometimes act irrationally driven by group-think and emotions such as fear or exuberance. Accordingly, markets can be inefficient which explains asset booms and busts. I believe that these seemingly irreconcilable positions can be explained by two economic forces. First, rational individuals will not necessarily produce rational outcomes when acting as a group and second, since money is denominated in itself, changes in money demand affect the prices of other assets.
Let's explain the first force. When people make asset decisions they do act rationally and consider all the available information in regards to their individual preferences and expectations for return, risk, liquidity and carrying costs. There is a tremendous amount of uncertainty associated with each of those expectations, and individual decisions are not immune from error. However, for each buyer there is a seller, which means that in total someone's losses will be offset by someone's gains. If we stopped the analysis here, markets indeed would be perfectly efficient. However, markets suffer from a particular flaw - imperfect information. Specifically, market participants have no way of projecting the impact an individual decision can have on the macro-economy, which will ultimately exert an influence back on them.
For example, if I buy and sell a home for a nice
profit, my neighbor may attempt to do the same. The inflow of new investors drives home prices higher pushing down the potential return. The paradox of thrift offers another example. If I am uncertain about my job
prospects due to fear of a recession, I am likely to save more and spend less. However, because I am not dining out as much,
a local restaurant owner may cut down working hours causing his employees to worry
about their jobs. This initiates a cycle that turns fear into a self-fulfilling prophecy.
Clearly, there is a link between our actions and
the actions of the people around us; Because of this link, return is not independent of the decision whether to take a risk or not. If you don't take the risk, you are leaving money on the table. If you do take the risk, you're driving down returns for everyone. However, this interdependency is unknowable to individual participants. We cannot predict the ultimate chain of events that a specific
decision can precipitate. This information feedback loop simply does not
exist. As a result, risks do not offset perfectly but
rather tend to compound while the associated returns tend to decline, which is how I would define a bubble.