One of the big drivers of this financial meltdown were the econometric models that saw mathematics guiding investor behavior.

The reality is that the big drivers of bubbles are social and psychological. What's needed now is some sort of infrastructure that can anticipate our thinking, inhibit the growth of bubbles and stop the damage, not only to the economy but to the social fabric.

The Madoff scandal raises questions around the "efficient markets" theory. Do buyers and sellers of financial assets act rationally in deciding at what price they are willing to buy or sell a stock, bond, option, futures contract or other financial instrument? If they do act rationally, then the market prices of securities accurately capture their true value, based on all information available. The Madoff scam exposed that badly.

A recent article in Science magazine by Chelsea Ward explains how our decisions around money are not that rational at all, and how so many smart people got it so wrong. You can read snippets from her piece in Deric Bownds Mindblog. "Classical finance theory's model of speculative bubbles, such as the dot-com bubble of the late '90s and the recent housing bubble, does not match real-life observations. Classical finance contends that rational investors will always have the best possible portfolio, so they will not buy or sell unless they have extra money to invest or need to cash in their investments. However, researchers have observed that people buy and sell much more often than that during a bubble-with the rate of transactions becoming increasingly manic the bigger the bubble gets ... Psychologists have found that people often overestimate the precision of their knowledge. Scheinkman and his Princeton colleague Wei Xiong guessed that overconfident investors would trust their own opinions about the price of an asset, so they would consider others' opinions, if different, a little "crazy," says Scheinkman. Looking to make money off others' crazy opinions, investors would be willing to pay more than they think an asset is actually worth because they believe that they will be able to sell it in the future to an overeager buyer. This process would inflate prices and cause a trading frenzy ... In a 2007 paper in the Journal of Economic Perspectives, Wurgler and co-author Malcolm Baker, a financial economist at Harvard Business School, looked for signatures of investor sentiment-irrational optimism or pessimism-in stock-market data since the 1960s. They hypothesized that certain stocks would be more subject to sentiment than others: broadly speaking, stocks for which the true value is difficult to determine. For example, a young, promising company would fit the bill. "The combination of no earnings history and a highly uncertain future allows investors to defend valuations ranging from much too low to much too high," they write.
Comparing the stock-market data with their measure of investor sentiment, they found what they had expected. In optimistic times, difficult-to-value stocks were wildly popular and therefore made much more money than average. In pessimistic times, they were wildly unpopular and therefore made much less money than average. On the other hand, easy-to-value stocks, which are considered safer, were more popular in pessimistic times than optimistic ones, but their prices stayed much closer to average. This helps explain past bubbles in certain types of stocks-say, dot-com stocks in the 1990s-and is also useful for making predictions for the future."

As psychologist Lawrence Raifman says, markets are driven by fear and greed more than they are by rational or optimal decisions. So much for the rational investor.

I explain how maths contributed to the meltdown in my piece here.