Psychological Points of Equilibrium in Asset Valuation During Market Bubbles

Abstract

This paper presents the concept of psychological point of equilibrium (PPE), which is a mental state achieved by average investors when trying to make decisions during market bubble's inflationary stages. The PPE results from an interplay between agents acting in a volatile market that is characterized by predatory behaviors. Prior to the 2008 subprime crisis, average investors are assumed to have displaced their logical PPEs in large part as a consequence of their attraction towards predatory mortgages and teaser rates. A better understanding of average investor's vulnerabilities may help governments to implement more efficient measures aimed at curving predatory behaviors.

Keywords:

• Perceived predation
• Consolidated model of financial predation (CMFP)
• Financial predators
• Market bubbles
• Psychological point of equilibrium (PPE)

Notes

1. This is referred to as predator position in the CMFP, versus the prey position, which is exemplified by those who lost following the 2008 crisis. A market agent can be predator or prey at the same time or at different points in time.

2. Campello and Graham [2013] refer to “non-bubble sectors.”

3. DeMarzo, Kaniel and Kremer ([2007], p. 736), however, remark that “in many cases, as in the above example, bubble-like behavior coincides with periods and industries undergoing a concentration of technological innovation.” So Th plays a role in inciting investors to accumulate Rn because Rn has technologically improved; this is in line with Zeira (1999)'s assumption about the incidence of market expansion.

4. In cases others than NINJA's, work (T) is the main guarantee covering mortgages (Rn). However, home ownership reduces labor mobility and slows down recovery (Ferguson [2008]).

5. Scherbina and Schlusche [2013] argue that real estate markets are more prone to bubbles because they involve unsophisticated households and short-sale constraints among other factors.

6. From an average investor's perspective, the accumulation of Rn precedes the accumulation of knowledge (Th), which then fosters the demand for Rn (a dynamic that feeds greed during market bubbles' inflationary stage). Financial education prior to decision making also enhances the quality of decisions (Wang [2009]).

7. For ease of argumentation, we do not include an error term.

8. As discussed in a previous work (ANH [2013]), R and Rn entertain a contrasting relationship. When people accumulate essential resources R, they cannot accumulate non-essential resources Rn at exactly the same time. Hence, in the output functions, R and Rn are presented in a different order: E = z + ß0 RnαTh (1-α) where Rn comes first, and E'= z' - ß0' Tα R(1-α), where R comes second.

9. ANH [2013a] has proven that this is actually taking place from a neurobiological point of view, given that the pituitary gland cannot respond back to the hypothalamus (in the HPA axis) except by releasing hormones through the blood system, which then feedbacks to the hypothalamus, in particular through the ventral tegmental area (VTA).

10. One can also calculate the predator/prey ratio for every group listed in Appendix A to see that it averages about 1.3 and to confirm the relationship between trust and cooperation, and to verify that equilibrium does indeed serve as a statistical mediating variable using Baron and Kenny's 1986 test (see ANH and Lévy-Mangin [2013]). Some key statistics are provided in Appendix A.

11. The body's homeostasis is controlled by the part of the brain called the hypothalamus, which is responsible for predatory (instrumental aggression) behaviors (lateral hypothalamus) and prey behaviors (e.g., escape, freeze, defensive hostility–medial hypothalamus).