Financial Bubbles: Why Do Fools Fall in Love?

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My latest column on Money & Your Mind over at SmartMoney.com:

From the Dutch tulip mania of the 17th century to the dot-com bubble of the late 1990s to the real-estate bubble of the 2000s, something in our nature drives us ceaselessly to chase the next big thing — right off a cliff.

But what makes this cycle repeat itself over and over and over again? Why can’t financial regulations tame this beastly side of human nature? And don’t people ever learn from their mistakes?

The answer to that last question is key: They do, but only slowly, and each new generation needs to learn for itself — at least when it comes to financial assets.

That’s because financial assets are a rather odd kind of good for humans to wrap their minds around. When it comes to real goods, it’s relatively simple for the average person to decide what he or she is willing to pay for something. For cars and refrigerators, it’s about what they’re willing to pay. The stock market, on the other hand, is about what someone else is willing to pay. And, going by the bigger-sucker theory — I may have overpaid, but a bigger sucker will take this asset off my hands — you can almost always justify paying a little more if you’re sure an asset’s price is heading up.

And in a bubble, people are always sure the price is going up — even when they know its fundamental value remains unchanged.

Read on for some insights from Vernon Smith, Nobel Prize winning economist, and Paul Zak, a leader in the field of neuroeconomics. Read about how bubbles have been replicated in the lab and why the market in the real world never learns.