Question

Why is behavioral economics an important concept to understand when discussing the formation of asset bubbles? 'Irrational exuberance' leads to regular, mass sell-offs, driving asset prices down. During bubbles, forecasting errors lead to investors under-forecasting asset prices and therefore, not buying. Irrational exuberance' shown by investors can lead to inaccurate valuations of assets, leading to a 'snowball effect with consistent price increases. Higher asset prices lead to a framing bias where investors choose to buy more assets.

Answer 1

We need to first understand the concept of bubbles. A bubble means that the asset is over valued as compared to the intrinsic value of the asset and when such bubble becomes too big, it bursts because the asset values are not backed by substance.

Irrational exuberance implies that the investors are over optimistic of the asset's performance and therefore value it higher than its true value, this leads to mass buying raising the price even higher. So option 1 is incorrect as it states the complete opposite.

Framing bias is investors taking an incorrect decision because of the manner in which the assets prices are presented so that doesn't apply here.So option 4 is incorrect.

Option 2 states that in bubbles investors under-forecast while in reality they over-forecast so this option is incorrect.

Option 3 is correct as it defines the situation of irrational exuberance and bubble behavior correctly. And understanding this behavior is a part of behavioral finance.