Short Investment Horizons, Higher Order Beliefs, and Difficulty of Backward Induction: Price Bubbles and Indeterminacy in Financial Markets

This paper examines if markets populated by short-horizon investors tend to have the prices come unhooked from their fundamental values or cash flows. For prices to be near the fundamental value in a market populated with short-horizon investors, the investors must induct backward from future cash flows to the present values. We argue that investors’ ability to backward induct depends critically on strong and unrealistic assumptions about their first and higher order expectations about future cash flows and presence of common knowledge. Since these assumptions are rarely met, prices tend to deviate from fundamentals and become indeterminate. We examine this proposition by conducting laboratory asset markets with overlapping generations of short-horizon traders and comparing observed transaction prices to the fundamental values. Our results show that transaction prices are close to the fundamental values when traders have long horizons. They deviate significantly as investment horizons shrink (and backward induction to present values becomes more difficult).