Speculative Bubbles Dynamics and the Role of Anchoring

Abstract

We investigate the role played by the anchoring-and-adjustment heuristic in the speculative bubbles dynamics. In order to link anchoring bias and price deviations from fundamental value, we develop a stock market equilibrium model with heterogeneous investors: fundamental investor anchoring to past stock market prices and noise traders. The equilibrium model we derive suggests that price is a function of fundamental value, past price, noise and anchoring level. Based on our model, we run a set of Monte Carlo experiments with various anchoring levels: no anchoring, low anchoring and high anchoring. We bring the evidence that large speculative bubbles can only occur when fundamental traders highly anchor to stock market prices. Noise cannot in itself cause such phenomenon. Our findings also suggest that a high anchoring level is consistent with slowly mean reverting bubbles lasting many years.

Keywords: Anchoring, Behavioral finance, Bubbles, Experiment, Stock market

JEL Classification: G12, G14