Bubbles, psychology and the Blue Eyed Islander puzzle

I've just finished watching  Evan Davis' TV series "The City Uncovered"... This came on TV not long after Niall Ferguson's "Ascent of Money". Both are very good series trying to explain the current financial system and where it came from.

But they have both really annoyed me with their ridiculous attempts to explain the phenomena of "bubbles", or "boom and bust".

Niall's series pretty much said "Bubbles are caused by a herd instinct. Human beings are irrational, and we tend to all get ahead of ourselves, and that's how bubbles happen". (I'm paraphrasing here)

Evan's documentary went even further. He even interviewed one guy, John Coates, who reckoned that not only is it human "psychology" that causes bubbles, but that in particular it is male psychology, and the way that people react. Coates argued on tonight's TV program that testosterone makes people overly bullish, and cortisone makes them overly bearish, and that if only we had more women and older men doing the trading, then bubbles would not happen.

So, both seem to be saying "Bubbles are caused by human nature, and by the fact that people are ruled by their emotions".

I find this "explanation" so simplistic as to be offensive.

They should just admit that nobody really has a proper understanding of boom and bust.

I think the key to understanding the cause of boom and bust will be through the mathematics of puzzles like the Blue Eyed Islander puzzle. If you haven't heard of this puzzle before now, I advise you to visit that link first, and have a good think about it, then come back to read the rest of this!

It's a fantastic riddle. What's incredible about it, once you finally understand the answer, is that the public announcment of a seemingly inconsequential piece of information (I say "seemingly inconsequential" because everybody already knew that at least one person has blue eyes), ends up changing the situation entirely.

When the visitor says to all of the islanders in a public announcement that "at least one of you has blue eyes", each of the islanders now knows that a second islander now knows that a third islander now nows ... that a 100th islander now knows that at least one person has blue eyes. This is the abstract change in information that allows all 100 blue eyed monks to deduce the colour of their eyes after 100 days.

In the real world, the total amount of information that you acquire directly is actually pretty small. Most of the information that we acquire comes from other people who've acquired it from yet other people. Collectively, a population of a hundred million people might all know enough to deduce something, if we could all share that information with each other - but it's not even practical for us to be able to share our knowledge.

Think about this too: Nobody can point to any single event that caused the great stock market crash of October 24th 1929. Only 2 months earlier markets were booming and seemingly placid. What information was gained by everybody to cause them to realise that, indeed they were in a bubble?

I think it's very similar to the Blue Eyed Islander puzzle. You're an islander, you're looking at 99 other blue eyed islanders. You think you yourself might have blue eyes, but without the information about what the other islanders know, you can't be sure.

You're an investor. You think you might be in a bubble - prices keep going up - but you're not sure what the people who are buying know. If you knew everything that they knew, and could process all that information, then you'd be able to tell if it's a bubble or not. And it's not just a "greed/fear" thing. If you're a professional investor, whose job it is to trade in that market, you have to decide, each day, whether the market you are in is a bubble or not.

I remember listening to an analyst on CNBC back in 1995, after the Dow had recently risen something like 60%, to 5000. She thought it was a bubble, and had set an end of year target of 3000. Staying out of the market, playing it "safe" would have been just as costly as buying into it a few years ago.

I don't know what causes booms and busts either, but I do know it's a hell of a lot more complicated than testosterone.

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