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Advisors and asset prices: A model of the origins of bubbles

  • Hong, Harrison
  • Scheinkman, José
  • Xiong, Wei

We develop a model of asset price bubbles based on the communication process between advisors and investors. Advisors are well-intentioned and want to maximize the welfare of their advisees (like a parent treats a child). But only some advisors understand the new technology (the tech-savvies); others do not and can only make a downward-biased recommendation (the old-fogies). While smart investors recognize the heterogeneity in advisors, naive ones mistakenly take whatever is said at face value. Tech-savvies inflate their forecasts to signal that they are not old-fogies, since more accurate information about their type improves the welfare of investors in the future. A bubble arises for a wide range of parameters, and its size is maximized when there is a mix of smart and naive investors in the economy. Our model suggests an alternative source for stock over-valuation in addition to investor overreaction to news and sell-side bias.

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Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 89 (2008)
Issue (Month): 2 (August)
Pages: 268-287

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Handle: RePEc:eee:jfinec:v:89:y:2008:i:2:p:268-287
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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