Behavioral finance explains that investors are not always perfectly rational. Instead of making decisions solely based on fundamental information such as earnings, cash flows, or economic conditions, people are influenced by psychological biases and social pressures. Two of the most important behaviors that contribute to asset price bubbles are herd behavior and momentum trading.
Herd behavior
Herd behavior occurs when investors follow the actions of others rather than relying on their own analysis. The reasoning often becomes:
- "Everyone else is buying, so they must know something."
- Fear of missing out (FOMO) outweighs careful evaluation.
- Investors gain comfort from acting with the crowd, even if prices appear too high.
As more investors buy an asset, demand pushes the price upward. Rising prices then attract even more buyers, creating a self-reinforcing cycle.
For example:
- A company's stock is worth about $50 based on its fundamentals.
- Strong media attention and rising prices attract new investors.
- More buying pushes the stock to $70, then $90, then $120—even though the company's earnings have not improved significantly.
- Investors continue buying simply because others are buying.
Eventually, when confidence weakens, many investors try to sell simultaneously, causing prices to fall rapidly.
Momentum trading
Momentum trading is the strategy of buying assets that have recently increased in price and selling those that have been falling.
The underlying assumption is:
- Recent winners will continue rising.
- Recent losers will continue declining.
While momentum can sometimes reflect genuine improvements in fundamentals, it can also amplify price movements beyond what is justified.
The process often looks like this:
- Prices begin rising for a legitimate reason.
- Momentum traders notice the upward trend and buy.
- Their purchases push prices even higher.
- More investors join after observing the strong performance.
- Rising prices attract additional momentum traders.
This creates positive feedback, where higher prices generate more buying, which in turn produces even higher prices.
How herd behavior and momentum reinforce each other
These two behaviors often work together:
| Herd behavior | Momentum trading |
|---|
| Investors buy because others are buying. | Investors buy because prices are already rising. |
| Driven by social influence and fear of missing out. | Driven by observed market trends. |
| Increases demand regardless of intrinsic value. | Extends price trends beyond fundamental value. |
Together they create a powerful feedback loop:
- Prices start increasing.
- Momentum traders buy because of the trend.
- Herd investors join because everyone else is buying.
- Prices rise further.
- Media coverage and optimism attract even more investors.
- Asset prices become disconnected from their underlying value.
Why bubbles become irrational
An asset bubble is considered irrational because prices exceed what can reasonably be justified by expected future cash flows or earnings.
During bubbles, investors often display biases such as:
- Overconfidence: believing they can exit before the crash.
- Confirmation bias: paying attention only to positive news.
- Representativeness: assuming recent high returns will continue indefinitely.
- Greater fool thinking: believing someone else will pay an even higher price later.
As a result, prices become increasingly detached from economic fundamentals.
The bursting of the bubble
Bubbles typically burst when:
- disappointing earnings or economic news emerges,
- interest rates rise,
- investors begin questioning valuations, or
- confidence simply starts to fade.
The same behavioral forces then operate in reverse:
- Momentum traders begin selling as prices decline.
- Herd investors panic and follow.
- Falling prices trigger additional selling.
- The feedback loop accelerates downward, producing a sharp market correction or crash.
Real-world examples
Several historical episodes illustrate these dynamics:
- Dot-com bubble: Investors rushed into internet companies with little regard for profitability, expecting prices to keep rising.
- U.S. housing bubble: Rising home prices encouraged more buying, fueled by the belief that housing prices could not fall.
- GameStop short squeeze: Social media coordination, herd behavior, and momentum buying drove prices far above traditional valuation measures.
Summary
Behavioral finance argues that asset price bubbles arise because investors are influenced by psychological and social factors, not just fundamentals. Herd behavior encourages people to imitate others, while momentum trading encourages buying simply because prices are rising. Together, these behaviors create a self-reinforcing cycle that pushes prices above intrinsic value. When confidence eventually reverses, the same feedback mechanisms accelerate selling, causing the bubble to burst.
