The real reason it’s so hard to predict bubbles

If bubbles are so obvious, why do they keep happening? The real problem, according to Duncan Watts, author of Everything is Obvious: Once You Know the Answer, in his recent Slate article is how we learn from history

By analogy, when you're reading a mystery novel, you don't necessarily know what to make of events because you don't know how the story ends. But the novelist knows and is carefully including or excluding characters, scenes, and actions, all based on his or her intentions for the way the various pieces are going to fit together at the end.

History is told the same way. Historical explanations can only be constructed in retrospect because only once we know the outcome can we decide what to emphasize and what to ignore. If the envisioned social network economy fails to materialize, financial historians will cluck-cluck at all the warning signs that investors overlooked to drive up LinkedIn's stock; and if it does materialize, those very same actions will later be construed as bold and insightful.

Right now, however, investors don't have the benefit of knowing which of these future states of the world will be realized. For sure, they can imagine plausible endings, but everything we know about complex social systems tells us that outcomes are in large part random. Thus many endings are possible, and it's impossible to know, even in principle, which one of them will transpire.

For the same reason, it's impossible to know, even in principle, which information to pay attention to—because what is relevant now will only be decided by some future historian, who, like the novelist, can decide what was most relevant in the light of the ending that he or she knows about but that the participants themselves do not.

This is why, when we look back on bubbles, it seems to us that the explanation we have constructed is what really was happening and that investors at the time were falling for some contrived view of the world. Really, it's the opposite: The confusion we experience in the present is real. It is the story that we tell afterwards that is contrived.

Still curious? If you liked this, check out The ambiguities of Experience, Why we're Cowed by the Croud, and Why Expert Predictions Fail and Why we Believe them Anyway.

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