Individual Trader Behavior in Experimental Asset Markets

I investigate the behavior of individual investors in an experimental asset market that features a bubble. Subjects trade a risky asset at prices that do not change in response to their trades. The prices are taken from the outcome of a previous asset market experiment. This unique setup makes it possible to identify behavioral di¤erences between subjects who understand asset fundamentals and those who do not, and also to isolate the factors driving asset demand. I …nd broad similarity between the behaviors of subjects with di¤erent levels of understanding. Even subjects who demonstrate good understanding of fundamentals tend to buy at prices that they know to exceed those fundamentals, thus giving up chances for certain gains. These subjects’ trading decisions are in‡uenced by their predictions of short-term price movements, showing that speculation exists in this market. I also …nd that lagged asset prices are a strong predictor of trading behavior, indicating a possible role for a type of herd behavior, in which subjects erroneously use the price as a signal of asset value. These results shed light on why bubbles may persist despite the presence of rational traders in the market. 1 Introduction Many severe and protracted recessions begin just after the occurrence of large and rapid rises and crashes in asset prices, commonly known as asset-price "bubbles." In particular, the U.S. …nancial crisis of 2008 and the deep recession that followed were immediately preceded by a large rise and crash in U.S. housing prices. This begs the question: Do the asset price movements actually cause the slumps in real output? That possibility makes the "bubble" phenomenon an important target for research. 1 Disagreement exists as to whether these rises and crashes are rational responses to information about asset fundamentals, or whether they represent large-scale mispricings. In fact, some economists use the term "bubble" to refer only to episodes in which prices exceed fundamentals. Thus, the literature contains (at least) two alternative de…nitions for bubbles, one phenomenological and the other theoretical: 1. De…nition 1 (phenomenological): A "bubble" is an "upward [asset] price movement over an extended range that then implodes" (Kindleberger 1978). 2. De…nition 2 (theoretical): A "bubble" is a sustained episode in which assets trade at prices substantially di¤erent from fundamental values. It is di¢ cult to determine empirically whether bubbles in the sense of De…nition 1 are also bubbles in the sense of De…nition 2, since real-world fundamentals are rarely known. Laboratory experiments are thus an attractive technique for studying bubbles, since the experimenter knows fundamental values with certainty. Importantly, this represents a rare instance in which lab experiments may have direct relevance for understanding macroeconomic phenomena. The classic "bubble experiments" of Smith, Suchanek, and Williams (1988) found dramatic mispricings that resembled real-world bubbles. However, the validity of these "lab bubbles" has been questioned by subsequent research. Many researchers suggest that the mispricing in these experiments is purely due to subject confusion about fundamental values when subjects correctly understand fundamentals, these researchers say, "lab bubbles" invariably disappear. This critique is closely related to a common theoretical argument against the existence of bubbles, i.e. the idea that well-informed traders will "pop" bubbles by selling when prices are above fundamentals (Abreu and Brunnermeier 2003). The question of whether large, sustained asset mispricings can exist, in the lab or in the real world, hinges on the question of whether traders with good information about fundamentals tend to "join" bubbles. Theories exist as to why they might. One idea is that well-informed traders may engage in speculation, ignoring their understanding of fundamentals in order to bet on price movements and reap a capital gain1. A second idea is herd behavior, in which traders choose to ignore their own information about fundamentals in order to "follow the market". Herding might apply to sophisticated traders directly, or could provide a coordination mechanism for irrational "noise" traders whose collective 1Indeed, some economists consider speculation to be so central an explanation of bubbles that they de…ne a "bubble" only as a mispricing caused by speculation; see, for example, Brunnermeier (2007).