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Bubbles arise from positive feedback mechanisms from "summary" of Why Stock Markets Crash by Didier Sornette
Bubbles are a fascinating phenomenon that can arise in various markets, from stocks to real estate. These bubbles are not random events, but rather the result of positive feedback mechanisms at play. Positive feedback mechanisms are self-reinforcing processes that amplify small perturbations into large movements. In the context of financial markets, positive feedback mechanisms can take many forms. For example, as prices of a particular asset start to rise, more investors may become interested in buying, leading to further price increases. This creates a feedback loop where rising prices attract more buyers, causing prices to climb even higher. Another example of a positive feedback mechanism is the "herding behavior" seen in markets. When investors see others making profits in a certain asset, they may feel pressure to join in to avoid missing out. This can lead to a domino effect where more and more investors pile into the asset, driving prices to unsustainable levels. These positive feedback mechanisms can create a bubble in the market, where prices become detached from their underlying fundamentals. Eventually, the bubble reaches a tipping point where it can no longer be sustained, leading to a sharp crash in prices. This crash can be triggered by a variety of factors, such as a change in market sentiment or a negative economic event.- Market participants can better prepare for potential crashes and mitigate their impact. Ultimately, bubbles are a natural consequence of the complex interactions that characterize financial markets, and studying them can provide valuable insights into the dynamics of market behavior.
