If things go really wrong, the result may be a financial bubble that – just like any bubble – sooner or later bursts, with dramatic consequences. Those with practical experience of financial markets will readily find themselves at home in this new theoretical and empirical analysis. In the 1990s there were a number of bubble-like developments where prices ceased to mirror fundamental values. The one that comes to mind first is perhaps the IT 7  See De Bondt, W.F.M. & Thaler, R. (1985), Does the stock market overreact?, J. of Finance 40, pp. 793–805; also Jegadeesh, N. & Titman, S. (1993), Returns to buying winners and selling loosers: implications for stock market efficiency, ibid. 48, pp. 65–91. 8  Cutler, D. Poterba,J. & Summers, L. (1991), Speculative dynamics, Review of Economic Studies 58, pp. 520–546. 9  See e.g. Tversky, A. & Kahneman, D. (1974), Judgement under uncertainty: heuristics and biases, Science 185, pp. 1124– 1131. 10  Shiller, R. (2000), Irrational Exuberance, Princeton University Press, New Jersey. 11  Janis, I.L. (1982), Groupthink (2nd ed. ), Houghton Mifflin Co., Boston. 12  Babad, E. (1987), Wishful thinking and objectivity among sport fans, Social Behavior: An International J. of Applied Social Psychology 4, pp. 231–240. 4  BIS Review 5/2001  bubble.
The risk profile’s covariation with the return on human capital has to be considered, too; perhaps a 16  8  Merton, R.C. (2000), Finance and the role of financial engineering in the 21st century, unpublished, Harvard University. BIS Review 5/2001  stockbroker, for example, should be wary of exposing even her/his personal financial savings to the stock market. Other risks lie in fluctuations in the price of a home that one either owns or is saving up for, as well as in the financing costs and, not least, the cost of refinancing; even if the mortgage rate is fixed, when the time comes to renew the loan it may be too high. The risks inherent in price fluctuations apply to other capital goods, too. It is also necessary to consider the risks in any saving plan for children’s education or for personal supplementary health insurance and life assurance. Perhaps it would even be advisable to allow for the risks that are covered today by insurance against fire, theft and accidents. Merton’s point is that there is a composite package of risks that is specific to each person and needs to be identified and covered. The management of all these risks calls not only for professional advice in the construction of such a plan but also for tailor-made financial products. The plan can include a variety of financial instruments but these must be easy for the individual household to understand in order to form a picture of and decide about the potential risks.