What Contribution Can Behavioural Finance Make to the Explanation of Stock Market Bubbles and Crashes?

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The occurrence of stock market bubbles and crashes is often cited as evidence against the efficient market hypothesis. It is argued that new information is rarely, if ever, capable of explaining the sudden and dramatic share price movements observed during bubbles and crashes. Samuelson (1998) distinguished between micro efficiency and macro efficiency. Samuelson took the view that major stock markets are micro efficient in the sense that stocks are (nearly) correctly priced relative to each other, whereas the stock markets are macro inefficient. Macro inefficiency means that prices, at the aggregate level, can deviate from fair values over time. Jung and Shiller (2002) concurred with Samuelson’s view and suggested that waves of over- and…show more content…
However there are times when irrational investors are dominant. A possible cause of market overreaction is the tendency of some investors (often small investors) to follow the market. Such investors believe that recent stock price movements are indicators of future price movements. In other words they extrapolate price movements. They buy when prices have been rising and thereby tend to push prices to unrealistically high levels. They sell when prices have been falling and thereby drive prices to excessively low levels. There are times when such naive investors outweigh those that invest on the basis of fundamental analysis of the intrinsic value of the shares. Such irrational investors help to generate bubbles and crashes in stock markets. Some professional investors may also participate on the basis of the greater fool theory. The greater fool theory states that it does not matter if the price paid is higher than the fundamental value, so long as someone (the greater fool) will be prepared to pay an even higher price. The theory of rational bubbles suggests that investors weigh the probability of further rises against the probability of falls. So it may be rational for an investor to buy shares, knowing that they are overvalued, if the probability-weighted expectation of gain exceeds the probability-weighted expectation of loss. Montier (2002) offers Keynes’s (1936) beauty contest as an explanation of stock market bubbles. The first level of the contest

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