Diagnostic Bubbles

43 Pages Posted: 26 Dec 2018 Last revised: 27 May 2022

See all articles by Pedro Bordalo

Pedro Bordalo

University of Oxford - Said Business School

Nicola Gennaioli

Bocconi University - Department of Finance

Spencer Yongwook Kwon

Harvard University

Andrei Shleifer

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Date Written: December 2018

Abstract

We introduce diagnostic expectations into a standard setting of price formation in which investors learn about the fundamental value of an asset and trade it. We study the interaction of diagnostic expectations with two well-known mechanisms: learning from prices and speculation (buying for resale). With diagnostic (but not with rational) expectations, these mechanisms lead to price paths exhibiting three phases: initial underreaction, followed by overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a byproduct of fast moving beliefs about fundamentals, which lasts only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.

Suggested Citation

Bordalo, Pedro and Gennaioli, Nicola and Kwon, Spencer Yongwook and Shleifer, Andrei, Diagnostic Bubbles (December 2018). NBER Working Paper No. w25399, Available at SSRN: https://ssrn.com/abstract=3306111

Pedro Bordalo (Contact Author)

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain

Nicola Gennaioli

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Spencer Yongwook Kwon

Harvard University

1875 Cambridge Street
Cambridge, MA 02138
United States

Andrei Shleifer

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States
617-495-5046 (Phone)
617-496-1708 (Fax)

HOME PAGE: http://www.economics.harvard.edu/~ashleife/

National Bureau of Economic Research (NBER)

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European Corporate Governance Institute (ECGI)

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Belgium

HOME PAGE: http://www.ecgi.org

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