Rational Panics and Stock Market Crashes

Abstract:     
This paper offers an explanation for crashes in the stock market which focuses on the role of rational but uninformed traders. We show that uninformed traders can precipitate a price crash because as prices decline, they reasonably surmise that better informed traders could have received negative information, which leads them to reduce their own demand for assets driving the price of stocks even lower. We also show the model yields several implications, such as the fact that crashes can occur even when the fundamental values of assets are strong, and that the magnitude of the crash depends on the fraction of uninformed investors and the amount of unsophisticated passive investing present in the market. Given increasing participation among uninformed traders and the growing popularity of aggressive trading in recent years, we conclude markets today might remain vulnerable to crashes that may be as severe as those which occurred in the past, in contrast with some of the conventional wisdom that argues such severe crashes have become less likely.

Note: Previously titled, ""On the possibility of Stock Market Crashes in the Absence of Portolio Insurance".

Number of Pages in PDF File: 27

JEL Classification: C14, D82, D84

working papers series