Do investors behave like lemmings?

Researchers from the Centre for Risk Research, University of Southampton, Professors Richard Dale and Johnnie Johnson and Dr Leilei Tang, have unearthed new evidence that investors in financial markets can behave irrationally. This key finding is a matter of great public concern affecting, as it does, pension funds, interest rates, economic stability and ultimately employment.

In the aftermath of the Japanese financial bubble of 1990s and the more recent global dot.com boom and bust, economists have hotly debated the question of whether or not investors are rational. A great deal depends on the answer because if financial markets are subject to extreme irrational movements, stock prices and the cost of capital may be distorted and economic activity disrupted.

The authors' research into the greatest stock market debacle of all time*, the South Sea Bubble of 1720, suggests that investors can indeed go mad. They use data that has never before been analysed to show that during the Bubble year the prices of successive issues of South Sea shares became so out of line with each other as to defy rational explanation. Careful statistical investigation also confirms that the prices of almost identical assets moved independently of each other as the bubble inflated - again demonstrating investor irrationality.

"Investors appear to have been caught up in a whirlwind of speculation and gambling," commented Professor Johnnie Johnson, "their appetite for gain led to an explosion of excitement, with rational judgement being one of the first victims."

The major conclusion of this research - that investors completely lost their bearings in the heady atmosphere of 1720 - has direct relevance to our understanding of today's financial markets. It seems that the dot.com boom-bust and the South Sea Bubble, though separated by nearly 300 years, are directly linked. The message for policy-makers is that even well-managed economies can be derailed by surges of excessive investor optimism.

According to Professor Dale, "Governments must in extreme situations be prepared to intervene to prevent unbridled speculation in asset markets, ranging from shares to property, if economic stability is to be maintained."

Ends

* 'Financial Markets Can Go Mad: Evidence from the South Sea Bubble', Economic History Review, May issue, 2005.