Advisors and Asset Prices: A Model of the Origins of Bubbles

Abstract:     
Many asset price bubbles occur during periods of excitement about new technologies. We focus on the role of advisors and the communication process with investors in explaining this stylized fact. Advisors are good-intentioned and want to maximize the welfare of their advisees. But only some understand the new technology (the tech-savvys); others do not and can only make a downward-biased recommendation (the old-fogies). While smart investors recognize the heterogeneity in advisors, naive ones mistakenly take whatever is said at face value. Tech-savvys inflate their forecasts to signal that they are not old-fogies since more accurate information about their type improves the welfare of investors in the future. A bubble arises for a wide range of parameters and its size is maximized when there is a mix of smart and naive investors in the economy. Our model yields a number of additional testable implications.

Keywords: Technology bubble, financial advisor, communication, reputation

JEL Classification: G10, G20

working papers series