Toward a Grand Theory of Bubbles

Abstract

In this chapter, we put forward our grand theory of bubbles that reflects pervasive irrationality, of individuals and markets and builds on three transcending constructs that explain the formation of bubbles regardless of the asset types. These are sentiment-guiding theory, sentiment, and newness of assets. One of our central insights is that during the stage of rapid bubble inflation, there is a tendency to discard sentiment-guiding theories rather than sentiments themselves. To help theorize the emergence of bubbles further, we turn to the concept of turning points, and also introduce a number of constructs such as ignorant belief toward a new asset, subjective probabilities, and illusionary certainty of negotiated mix. We argue in this chapter inter alia that ignorance and illusion of skill are phenomena present not only at the level of individuals, but also at the level of industries, and various private and public institutions for the society as a whole.