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Advisors and Asset Prices: A Model of the Origins of Bubbles

  • Harrison Hong
  • Jose A. Scheinkman
  • Wei Xiong

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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File URL: http://www.nber.org/papers/w13504.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13504.

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Date of creation: Oct 2007
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Publication status: published as Hong, Harrison & Scheinkman, José & Xiong, Wei, 2008. "Advisors and asset prices: A model of the origins of bubbles," Journal of Financial Economics, Elsevier, vol. 89(2), pages 268-287, August.
Handle: RePEc:nbr:nberwo:13504
Note: AP CF
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