Stock Markets, Market Crashes, and Market Bubbles

Abstract

The omnipresent and reoccurring market bubbles and crashes have been puzzling both finance professionals and academics. Important economic theories such as the efficient market hypothesis indicate that, rationally, mispricing of assets traded on stock markets should not occur. However, this is not the case in real life. Behavioral and neuroscientific studies have provided an important contribution to explaining the psychological mechanisms driving the behavior of individual stock market players as well as the market in general. This chapter presents the most influential scientific work devoted to stock markets, bubbles, and crashes. It provides a brief overview of the research aiming to explain behavioral phenomena on stock markets. First, it outlines the key terminology and classification of market bubbles and crashes. Second, it reviews the psychological and economic literature devoted to experiencing extreme financial events. Despite a low number of studies, the general conclusion is that experiencing a strongly negative financial event would lead to decreased risk-taking in the future. Next, the reader’s attention is drawn to a range of typical cognitive biases present in the stock market. Group-think, the disposition effect, overconfidence, and home bias are among the most researched biases. Finally, the chapter presents experimental asset markets—a strand of experimental studies investigating coordination on the stock markets. This type of work has gained prominence after the invention of the SSW design—the Nobel Prize winning experimental method. The chapter concludes with a short note on econophysics—a field that deals with simulation and prediction of stock market players’ behavior.