Overreaction, Momentum, Liquidity, and Price Bubbles in Laboratory and Field Asset Markets

Journal of Psychology and Financial Markets, No. 1, pp. 24-48, 2000

25 Pages Posted: 3 Sep 2009 Last revised: 13 Oct 2009

Gunduz Caginalp

University of Pittsburgh - Department of Mathematics

David Porter

Chapman University - Department of Business and Economics

Vernon L. Smith

Chapman University - Economic Science Institute; Chapman University School of Law

Abstract

Laboratory asset markets provide an experimental setting in which to observe investor behavior. Over more than a decade, numerous studies have found that participants in laboratory experiments frequently drive asset prices far above fundamental value, after which the prices crash. This bubble-and-crash behavior is robust to variations in a number of variables, including liquidity (the amount of cash available relative to the value of the assets being traded), short-selling, certainty or uncertainty of dividendpayments, brokerage fees, capital gains taxes, buying on margin, and others.

This paper attempts to model the behavior of asset prices in experimental settings by proposing a "momentum model" of asset price changes. The model assumes that investors follow a combination of two factors when setting prices: fundamental value, and the recent price trend. The predictions of the model, while still far from perfect, are superior to those of a rational expectations model, in which traders consider only fundamental value. In particular, the momentum model predicts that higher levels of liquidity lead to larger price bubbles, a result that is confirmed in the experiments. The similarity between laboratory results and data from field (real-world) markets suggests that the momentum model may be applicable there as well.

Suggested Citation

Caginalp, Gunduz and Porter, David and Smith, Vernon L., Overreaction, Momentum, Liquidity, and Price Bubbles in Laboratory and Field Asset Markets. Journal of Psychology and Financial Markets, No. 1, pp. 24-48, 2000. Available at SSRN: https://ssrn.com/abstract=665107

Gunduz Caginalp (Contact Author)

University of Pittsburgh - Department of Mathematics ( email )

507 Thackeray Hall
Pittsburgh, PA 15260
United States
412-624-8339 (Phone)
412-624-8397 (Fax)

David Porter

Chapman University - Department of Business and Economics ( email )

Orange, CA
United States
(714) 997-6915 (Phone)
(714) 628-2881 (Fax)

Vernon L. Smith

Chapman University - Economic Science Institute ( email )

One University Dr.
Orange, CA 92866
United States
714-628-2830 (Phone)

Chapman University School of Law ( email )

One University Drive
Orange, CA 92866-1099
United States

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