The behaviour of commodity prices and U.S./European housing market prices in 2008, the ‘dot-com’ boom in 1998-2000, all these events have been characterized as speculative price bubbles: persistent deviations from assets’ fundamental values with strong increases in asset prices in a continuous process. They are possibly the most controversial subject of finance, not only for the implications to risk management, but because their existence contradicts the assumptions of the Efficient Market Hypothesis (EMH).
Although some critics challenge the very existence of bubbles, even questioning the empirical tests developed in recent years, several studies have been carried out concerning speculative bubbles, and it is undeniable that the coexistence of high prices, high trading volumes and high volatility is not consistent with the assumptions of EMH, hence the need to use an alternative approach – behavioural finance – in order to better explain this phenomenon. This article aims to compare two approaches to bubble prices: one based on the EMH, the other based on a behavioural approach.
Bubbles and EMH
The idea that market prices will move toward equilibrium is a fundamental concept in the capital markets theory. Investors have homogeneous expectations, converging with respect to returns, variance and covariance of asset prices, just having different degrees of risk aversion. Any change in price will result in a strong pressure to restore the balance: in fact rational investors will eliminate the bubble before it develops, as it is stated by the EMH. However, bubbles exist. The occurrence of speculative bubbles is not only exciting for the challenge to EMH, but mainly to the practical effects post-bubbles. Akerlof and Shiller make the point that bubbles are not irrelevant; they produce severe effects on the real economy, affecting not only investors but a lot of people who never had anything to do with those assets.
Do bubbles exist?
Flood and Hodrick (‘FH’) have commented that although it is theoretically possible to imagine a relationship between high volatility and bubbles, empirical evidence of the existence of a bubble can be attributed to poorly designed models or inappropriate
empirical studies, some of which use samples of market prices to prove the existence of a bubble. They effectively deny the existence of bubbles and criticize the idea that the existence of speculative bubbles is evidence that markets are not efficient, based on what these authors called an unobservable construct: the inability to determine a rational ex-post price, the ‘real’ price after the bubble has burst.
What makes a bubble?
Whilst FH only consider high volatility as being a defining characteristic of a bubble, Scheinkman and Xiong3 (‘SX’) believe that the formation of bubbles is related to the coexistence of high prices, high trading volumes and high volatility in prices, something that occurred in several episodes that can be described as bubbles. SX did not focus their analysis on the possible determination of a rational price ex-post, but in the high trading volume vis-à-vis the market value of the stocks. SX cite that between the end of 1998 and February 2000 transactions involving stocks of internet companies accounted for 20% of the total amount traded on U.S. stock exchanges. However, the market capitalization of these companies never exceeded 6%.
Bubbles and investor behaviour
SX propose an analysis model of bubble formation based on the heterogeneous expectations of investors, generated by overconfidence. With heterogeneous expectations, investors have different expectations about the probability distribution of future cash flow. Overconfidence is defined as the belief by investors that their respective information is more accurate than that of other investors. It is related to the tendency of individuals to overestimate their ability in relation to others. SX’s asset pricing model considers that an investor makes up the price from their own vision of what would be the fundamental price, and that they have (besides, of course, the asset itself) a put option on this asset. The value of this option can be reasonably understood as corresponding to the bubble. They do not work with the hypothesis of an observable rational price ex-post as being an important way of determining the existence of a bubble. The relationship between price bubbles and fundamental market prices or with the high trading volume clearly separates the two approaches. High volatility, high prices and high trading volumes are not compatible with the EMH approach, which means we have to look elsewhere to understand why bubbles occur. Behavioural finance, using the relationship of price bubble and speculative trading (i.e., high trading volumes with high volatility in prices), allows a theoretical and investigative way to resolve the difficulty of determining a rational price ex-post.
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