Bubbles, Human Judgment, and Expert Opinion

Research in psychology tells us how even the experts can get caught up in speculative bubbles. The widespread public disagreement about whether the stock market has been undergoing a speculative bubble since about 1995 reflects an underlying disagreement about how to view human judgment and intellect. The concept of a speculative bubble seems to require that some form of investor credulity or foolishness be at work. The disagreement is about whether we can in reality attribute such foibles to investors—notably, whether it is plausible to attribute such weaknesses to professional investors, the experts, who were apparently no more detached from the alleged bubble than other investors.Research in psychology has highlighted well-documented patterns of error that are widespread in human beings. These errors might explain the mistakes of the experts, as well as of everyone else. Some of the errors are individual cognitive errors. The representativeness heuristic is a failure to account for base-rate probabilities. Overconfidence is a tendency to overestimate one's unique abilities and information. Attention errors arise from an inconsistent focusing of our energies. And the wishful thinking bias is a tendency to ascribe too high a probability to a desired outcome.Other errors are social in origin. There is a tendency in people toward herd behavior. Herd behavior is not necessarily the blind following of others. Indeed, investors must take account of the opinions of others because no one person can research everything individually. A fundamental difficulty that all investors face, then, is how to judge the source of opinions that others have about the outlook for investments. We would like to pool the information that the others used to arrive at their opinions, but we cannot know where they received their information. In certain circumstances, we may assume that more information underlies their pronouncements than actually exists.This problem affects even our interpretation of stories presented in the media. The origins of many reports may lie more in a journalistic desire to tell a good “new era” story than to convey the ambiguity of the facts.Getting at the truth about the future involves dealing with true uncertainty—our fundamental lack of knowledge. We do not have quantitative probabilities of future possible events. We must, instead, judge their likelihood by reference to intuitive extrapolation of historical cases or to impressions of general societal and business trends.Business organizations, bureaucracies, and endowment, investment, and political committees—all filled with experts—are fundamentally ill equipped to make judgments about uncertain futures. When they attempt to deal with true uncertainty in a professional manner, “groupthink” can emerge. One cause of groupthink is the fear of being marginalized by expressing dissent. Groupthink can thus lead to errors in judgment and disastrous actions. When expert decisions about asset allocation are subject to groupthink, the errors may not be corrected even by the strongest doubters and may lead to flawed inferences and the amplification of a speculative bubble.Some contributors to errors in judgment are legal in origin. The “prudent person standard,” for example, which fiduciaries must honor and advisors must respect, requires that these experts temper their independent judgments and follow what a prudent person would find sensible. The problem with this standard is that the expert has no way to distinguish the sensible from the conventional, so the standard makes these people interpreters of conventional wisdom rather than investment professionals. At the time of a speculative bubble, the conventional wisdom and the very concept of prudence may be influenced by the bubble.When considered together, the evidence about sources of human error implies that experts are often caught up in speculative bubbles along with everyone else.