Bubbles and Financial Professionals

Research Retrieved: May 2019
Retrieve the paper from the SSRN

Issue

The efficiency of financial markets is a much-debated topic. The existence of bubbles and crashes shows the occurrence of periods of inefficient prices that strongly deviate from fundamentals. So far, little is known about whether these periods of inefficient prices occur solely due to inexperienced investors, or whether financial professionals also contribute to them. In an experimental study, the authors assess whether markets that include financial professionals are less likely to produce bubbles, as compared to markets that include student subjects.

To observe the conditions under which bubbles occur, the authors manipulate, between treatment groups, the cash to asset-value ratio, which is the total amount of money in the market over the fundamental value of shares outstanding. Historically, the emergence of bubbles has often been preceded or accompanied by expansive monetary policy, high leverage of market participants, lending booms, and capital inflows. Hence, the authors expect that an increasing amount of capital available in the market increases the probability of bubble formation. Further, the authors manipulate between treatment groups whether short sales were possible, which they expect to reduce the probability of bubble formation.

Key Findings

  • In the experimental markets, professionals are susceptible to bubble drivers, such as capital inflow or high initial capital supply. Bubbles formed in a quarter of all markets with financial professionals. Hence, even high-skilled financial professionals are not immune to bubble-drivers.
  • When short sales were possible and when a low initial cash to asset-value ratio was provided, none of the markets populated by professionals exhibited bubble patterns.
  • Markets with professionals showed significantly less overpricing and also fewer and smaller bubbles than markets with students in the presence of bubble drivers. In the absence of bubble drivers, however, professionals and students show similar levels of high price efficiency.
  • Mixed markets of professionals and students, with public knowledge about the trader composition, exhibit levels of price efficiency similar to markets solely populated by professionals. This indicates that professionals act as stabilizing device in markets with less experienced (non-professionals) traders.

Relevance for Practice

Bubbles, crashes, and their underlying drivers are interesting to study, as they represent periods where prices strongly deviate from fundamentals and have the power to severely affect the economy through misallocation of resources. The authors’ findings give insights on the extent to which different investor groups (inexperienced investors and financial professionals) contribute to price efficiency and speculative bubbles. The authors provide controlled evidence that even high-skilled financial professionals are not immune to bubble-drivers, but less so as compared to inexperienced investors. Also, in mixed markets, professionals act as price stabilizers.