Abstract
In this paper, I develop a model of self-reinforcing financial fads in which feedback patterns arise because of limitations to traders' observational learning. I assume that the traders categorize price history into finite groups of price patterns due to their cognitive limitations, but their learning is rational subject to these constraints. Under asymmetric information about the fundamental value of the traded asset, the uninformed traders choose to follow the price trends as long as they perceive that the trends correctly reflect the true fundamentals. I find that abnormal price movements involving feedback loops endogenously emerge intermittently because the uninformed traders optimally follow even the abnormal price movements due to the coarseness of their learning. My findings have implications for bubble-like price patterns as well as momentum, reversal, and technical analysis.
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