Another Law of Small Numbers: Patterns of Trading Prices in Experimental Markets

Abstract

Studies in neuropsychology show that the human brain processes small and large numbers differently. Small numbers are processed on a linear scale, while large numbers are processed on a logarithmic scale. In this paper, we report the results of an experiment showing that trading prices on experimental markets are processed differently by participants, depending on their magnitude. Deviations from fundamental values are larger in small price markets than in large price markets. Our experimental design allows us to confirm the result at the individual level. For a given participant, the deviation from the fundamental value is 27.27% on average when she trades on a small price market compared to about 0% on a large price market. Our results show that price magnitude influences the way people perceive the distribution of future returns. This result is at odds with standard finance theory but is consistent with: (1) a number of observations in the empirical finance and accounting literature; and, (2) the use of different mental scales for small and large prices.

Keywords: Experimental markets, number perception, behavioral bias, stock price magnitude, mental scales