difficulty of speculating against a strongly rising market that is driving prices above estimates of fundamental values. you may recall that john maynard keynes once cautioned against such a strategy by warning that “ the market can stay irrational longer than you can stay solvent. ” one explanation for this is that speculating against the market requires a critical mass of investors that will act in synchronised or coordinated manner and will be able to push prices back towards fundamental values. this may not be easy when markets are deep and liquid as they tend to be during upswings. the “ coordination problem ” may therefore substantially delay arbitrage. 3 indeed, it might be rational for each individual investor to aim at riding the bubble ( just ) until the moment before it bursts, and this can explain the apparent contradiction between what investors do and what they believe to be fundamentally justified. 4 a second reason why speculation against a rising market may be limited is that there are few incentives to do so. payoff - structures and compensation schemes tend to encourage riskloving attitudes. compensation contracts that fail to incorporate sufficient “ historydependence ” can similarly lead to risk - loving behaviour : a fund manager whose bonus depends on his or her annual performance is likely to prefer a volatile environment which may be characterised by a sequence of bonanza years followed by a year or two of crisis and doom, rather than a more stable environment. a third possible explanation, which is “ rational ” from an individual investor ’ s point of view, is that if taking investment positions against the market eventually fails to be profitable, it will carry the stigma of an unsuccessful investment manager, while being wrong with the crowd is likely to be considered to be just bad luck. but the music will eventually stop playing. and it will stop playing when the orchestra realises that market value is totally out of tune with any reasonable expectations of future returns. as perceptions and attitudes gradually change, seemingly minor events can produce large changes in valuations. in august 2007, the difficulties emerged when it was recognised that some of the assets – initially those backed by sub - prime mortgages – turned out to be more risky investments than previously thought. this meant that structured investment vehicles ( sivs ), hedge funds and other investors suffered losses in relation to the value of these securities. this in turn caused the liquidity providers to these investors to reassess the value and risk of the collateral offered against their funding and to demand higher margins. the resulting funding problems forced investors in mortgage -

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