Henry Blodgett's article on why bubbles are recurrent phenomena in markets is very good, and gets at something I've been struggling to articulate. So I'm going to quote a substantial portion of it:
Being bullish in a bull market is undeniably good for business. When the market is rising, no one wants to work with a bear. Which brings us to the last major contributor to booms and busts: self-interest.When people look back on bubbles, many conclude that the participants must have gone stark raving mad. In most cases, nothing could be further from the truth.In my example from the housing boom, for instance, each participant's job was not to predict what the housing market would do but to accomplish a more concrete aim. The buyer wanted to buy a house; the real-estate agent wanted to earn a commission; the mortgage broker wanted to sell a loan; Wall Street wanted to buy loans so it could package and resell them as “mortgage-backed securities”; Alan Greenspan wanted to keep American prosperity alive; members of Congress wanted to get reelected. None of these participants, it is important to note, was paid to predict the likely future movements of the housing market. In every case (except, perhaps, the buyer's), that was, at best, a minor concern.This does not make the participants villains or morons. It does, however, illustrate another critical component of boom-time decision-making: the difference between investment risk and career or business risk.Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers.If the market goes up 20 percent and your Fidelity fund goes up only 10 percent, for example, you probably won't call Fidelity and say, “Thank you.” Instead, you'll probably call and say, “What am I paying you people for, anyway?” (Or at least that's what a lot of investors do.) And if this performance continues for a while, you might eventually fire Fidelity and hire a new fund manager.[...]In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients. The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational...[It is their] job to make money no matter what the market [is] doing, not to insist that the market [is] wrong.
There's a related quote along these lines: "The market can remain irrational longer than you can stay solvent." Most of the traders did the right thing for their careers. They responded to their market incentives correctly. Going against the tide would have been foolish. If an investment bank executive had declared a moratorium on bad investments, he would have lost his job. Blodgett relates the story of Julian Robertson, a legendarily obstinate hedge fund manager who correctly recognized the tech boom as as an unsustainable bubble. "By 1998, Robertson was short Amazon and other tech stocks, and by 2000, after the NASDAQ had jumped an astounding 86 percent the previous year, Robertson's business and reputation had been mauled. Thanks to poor performance and investor withdrawals, Tiger's assets under management had collapsed from about $20billion to about $6billion, and the firm's revenues had collapsed as well. Robertson refused to change his stance, however, and in the spring of 2000, he threw in the towel: he closed Tiger's doors and began returning what was left of his investors' money." The next year, of course, his stance would have won big. On some level, the market's meltdown was a collective action problem. No one trader could really have stopped it. Indeed, it makes me think Robert Rubin was just being very literal: He wouldn't have done anything differently because there was nothing different to do. Citibank's executives and traders would have suffered more if they had demanded the bank sat the madness out. It's possible, in fact, that the bank itself would be in worse shape if it had spent the last five years losing investors because they refused to offer anything but lackluster returns. Going bust and getting bailed out was the right thing to do. The market can't self-correct to stop bubbles (though it can punish them). The collision between market incentives and the short memories of investors is why we have bubbles. You can argue that Greenspan could have stopped it, but that's about it. The market cannot see clearly enough to correct the market's problems. There's a reason doctors do not heal themselves.
