Bursting the bubble

22nd August 2003 at 01:00
Anthony Neuberger finds that even a mathematician can lose heavily on the stock market

A MATHEMATICIAN PLAYS THE MARKET. By John Allen Paulos. Penguin Books pound;12.99.

What do you do if you've lost a packet gambling on the stock market, and you've been hiding your losses from your wife? To make matters worse, you've been swept up in a market bubble that people at the time identified as "the madness of crowds". And to crown it all, you're a professor of mathematics who has made an international name among students and readers for demystifying, explaining and applying rationality and mathematics to life.

The answer is, you write a book exploring the theory of markets, the limits to rationality, the role of chaos, and how small causes can have large effects. The reader ends up learning a lot about markets, but little about the nature of the addiction, or even how much John Paulos lost betting on the fraudulent telecoms company Worldcom when he bought shares on margin and increased the size of his bets as the price collapsed in 200001.

The perplexing questions about the stock market bubble remain. It is tempting to dismiss the market as a giant casino that has little to do with the real economy. But that is not true; billions of real dollars were spent on real investments that are of no real value.

Why did the bubble occur? The signs were clear. Investment banks had to create valuation models that were clearly disconnected from reality to justify the prices at which they were selling new shares. People who had no knowledge, insight or experience exchanged their day jobs for day trading and blew their savings via the internet.

Many private investors and institutional funds could have made money in the long term by speculating against it. Why were they not powerful enough to deflate it earlier?

There are some fragments of an answer in Paulos's book. In the short term, the speculator is betting on what others will think tomorrow, not on the fundamental value of the share. People are not rational, but suffer from persistent psychological biases. A connected network of investors will behave in counter-intuitive ways: it may respond to external stimuli only with long delays, and the size of any response may seem disproportionate.

These ideas are stimulating, but Paulos's answer is not coherent.

It would be nice to know what encourages and what inhibits bubbles, how frequently they are likely to occur, and how to make rather than lose money in a future bubble. An essential ingredient is a supply of gullible investors with "psychological biases".

A sad lesson from this book is that a thorough training in applied mathematics is not sufficient to immunise someone from such self-damaging irrationality.

Anthony Neuberger is associate professor of finance at the London Business School

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