Question

How does overconfidence lead to bubbles?

Use the limits to arbitrage argument to argue that markets are not efficient

Answer 1

Bubble could be a state of affairs wherever discovered sources soar way above fundamentals and rational analysis would counsel.

We tend to over-estimate our intelligence and capabilities relative to others. lxxiv p.c of skilled fund managers in the 2006 study “Behaving Badly” believed that they had delivered above-average job performance.
The greater fool theory posits that rational folks can commit valuations that they don’t essentially believe, as long as they believe there's some other person additional foolish UN agency can decease for a good higher worth. The human tendencies delineate on top of result in a reasonably inevitable outcome: when associate degree innovation is introduced and a market is made, folks believe each that they're among the few UN agency have noticed the trend early, which they're going to be sensible enough to tug out at the correct time.

Limits to arbitrage could be a theory that assumes that restrictions placed upon funds, that might commonly be utilized by rational traders to arbitrage away rating inefficiencies, leave costs during a non-equilibrium state for prolonged periods of your time.


The economical market hypothesis assumes that whenever mispricing of a publicly-traded stock happens as a results of associate degree over-reaction to news, or some similar event, associate degree opportuntity for low-risk profit is made for rational traders. The low-risk profit chance exists through the tool of arbitrage, which, briefly, is shopping for and mercantilism otherwise priced things of a similar worth, and pocketing the distinction. If a stock falls far from its equilibrium value (let United States say it becomes undervalued) thanks to irrational commercialism (noise traders), rational investors can (in this case) take an extended position whereas going short on a proxy security, or another stock with similar characteristics.