Bubbles in Experimental Asset Markets: Irrational Exuberance No More

Abstract

Abstract: The robustness of bubbles and crashes in markets for finitely lived assets is perplexing. This paper reports the results of experimental asset markets in which participants trade two assets. In some markets, price bubbles form. In these markets, traders will pay even higher prices for the asset with lottery characteristics, i.e., a claim on a large, unlikely payoff. However, institutional design has a significant impact on deviations in prices from fundamental values, particularly for an asset with lottery characteristics. Price run-ups and crashes are moderated when traders finance purchases of the assets themselves and are allowed to short sell. JEL classification: C92, G14 Key words: bubbles, asset markets, laboratory experiments, rational expectations ********** One of the most striking results from experimental asset markets is the tendency of asset prices to bubble above fundamental value and subsequently crash. Explaining the price pattern is a challenge. Yet extreme price movements, at odds with any reasonable economic explanation, are documented throughout history. Examples include the Dutch tulip mania (1634-1637), the Mississippi bubble (1719-1720), and the stock market boom and crash of the 1920s (see e.g., Kindelberger (1989), Garber (1990), White (1990)). More recently, in a speech made on December 5, 1996, Federal Reserve Chairman Alan Greenspan expressed concern that stock prices are inflated by irrational exuberance. The current debate over rational valuation centers largely on internet-related companies. Though downward price adjustments have been observed of late, stock prices for many of these so-called dot-coms increased at incredible rates over the last decade despite mounting accounting losses. Price to earnings multiples for some dot-coms (or price to revenues when earnings are negative) were as high as several hundred to one, something unheard of just ten years ago. Chairman Greenspan speculates that the observed price behavior might reflect a lottery effect. Market participants are willing to pay a premium for some stocks because, though the chance is small, a very significant payoff is possible. (1) This paper reports the results of experimental asset markets designed to examine whether asset prices reflect a lottery premium. The results indicate that traders will pay a premium for a claim on a large payoff, even if the payoff is unlikely. In addition, this study re-examines whether institutional design impacts upward deviations in prices from fundamental values. Unlike previous research that documents the robustness of bubbles formation, price run-ups and crashes are not observed when traders are not permitted to finance purchases with borrowed funds but are allowed to short sell the assets. The remainder of this paper is organized as follows. Section I provides background and motivation for the study. Section II describes the experimental procedures and design. Section III reports the results. Section IV contains a discussion of the results and concluding remarks. I. Regularities, Institutional Features, and New Questions Smith, Suchanek, and Williams (1988) first reported bubbles in experimental asset markets. Typically in bubbles markets, subjects trade an asset over a finite horizon. The asset has a common dividend, determined at period end based on a known, stationary probability distribution. Thus, fundamental value, assuming risk neutrality, is easily computed as the number of trading periods remaining multiplied by the expected dividend per period. In this setting trading yields large upward deviations in prices from fundamental value followed by crashes back to the asset's risk neutral value. The finding has been replicated by Porter and Smith (1995), Ackert and Church (2000), and Lei, Noussair, and Plott (2001), among others. King, Smith, Williams, and Van Boening (1993) investigate whether bubbles are moderated by several treatment variables including the ability to short sell, margin purchases, the presence of brokerage fees, equal endowments across traders, a subset of informed traders, limit price change rules, design experience, and experience in the business world. …