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Stock Market as a 'Beauty Contest': Investor Beliefs and Price Bubbles sans Dividend Anchors

  • Shinichi Hirota


    (Graduate School of Commerce)

  • Shyam NMI Sunder


    (School of Management)

We experimentally explore if the absence of dividend anchors (from which investors can backward induct to arrive at the fundamental value) may help us understand the formation of security price bubbles. The fundamental value models assume that the investors (a) form rational expectations, (b) form higher-order beliefs, (c) the security matures in finite time, and (d) that these three conditions are common knowledge among the investors. We argue that when the deviation of security markets from these assumptions deprives the investors of any reasonable way of backward inducting the fundamental value of a security from its future dividends, its price is susceptible to floating freely. We create laboratory markets with exogenously and endogenously specified terminal values, and examine whether the absence of a dividend anchor generates price deviations from the fundamentals. We find that such deviations occur in sessions where it is difficult for investors to backward induct value from dividends. Bubble price levels appear to be indeterminate, and price predictions follow a first-order adaptive or trend process. These processes are consistent with the conjecture that the investors resort to forward induction when backward induction becomes difficult or impossible. Under these conditions, the allocative efficiency and the cross-sectional dispersion of wealth also become indeterminate, as compared to high efficiency and low dispersion in the absence of bubbles.

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Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm271.

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Date of creation: 25 Nov 2002
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Handle: RePEc:ysm:somwrk:ysm271
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