This is an relevant excerpt of "layman explanations" from an article at hayloproperty.co.uk applicable to 2010 as Australia becomes a global economics text-book showcase of an extreme housing bust exacerbated by grave government policy mistakes at the most critial time.
The psychology of bubbles:
A speculative bubble creates a buy now or pay more later mentality. In any asset market, whenever price appreciation becomes the main reason for people buying, the market is in danger of becoming a bubble. This mentality creates a panic or a euphoria where everyone rushes to get in on it before it's too late.
There are several human psychological reasons for why bubbles form, which come from a very interesting area of study called behavioral finance:
1) Prospect theory through mental framing people begin to regard recent gains as play money. They feel happy to reinvest, even in high-risk areas or at highly inflated prices because they have not yet incorporated the gain into their sense of wealth. In a long bull market this explains how investors are happy to reinvest their gains. This creates a positive feedback loop where gains are reinvested and support the higher prices.
2) Anchoring people feel happy to invest in properties or stocks even when they are expensive compared to historical values because the price has been that way for a long time which makes it seem normal and comfortable. Anchoring also works to make people believe that returns will continue on their current trend. Anchoring is a powerful concept that real estate agents use to get higher prices for properties, by advertising the property at a highly inflated price, the buyers anchor to this price and think they are getting a bargain if they get a discount from this price, when in reality they are paying way over and above what something is worth. Thats just what you pay these days is a common thing people will say to justify higher prices during a bubble.
3) Overconfidence overconfidence is a classic human trait. For example in driving surveys asking people whether their driving ability is below average, average, or above average, most people will say above average. One aspect of overconfidence is to believe that history is irrelevant and no help to the future.
4) Herd instinct another familiar behavioral trait. Even professional investors have a tendency to go with the herd. In fact most institutional fund managers are prone to this.
5) Cognitive dissonance the mental conflict that people experience when presented with evidence that their beliefs or assumptions are wrong. This explains why people seek out views and opinions that reinforce our chosen view. In reaction to bubbles this explains why people may become disinterested, or even angry, when they hear reports that the market is overvalued. Instead they will focus on articles offering encouragement that shares or houses are not overvalued and could go even higher.
