1. 1 Price Bubbles sans Dividend Anchors: Evidence from Laboratory Stock Markets Shinichi Hirota (Waseda University) and Shyam Sunder (Yale University) Odette School of Business, University of WindsorFebruary 1, 2008

2. 2 Purpose Explore Why Bubbles Occur in Stock Markets. Focus on Effect of the Investors Time Horizon Conduct Laboratory Experiments.

3. 3 Main Result from the Lab Bubbles Arise if investors have short-term horizons and difficulty in backward induction.

4. 4 Previous Research on Bubbles (A) Rational Bubbles Blanchard and Watson (1982), Tirole (1985) Infinite Maturity (B) Irrational Bubbles Shiller (2000), Behavioral Finance Emotion, Psychological Factors

5. 5 Our Paper Provides a different view. includes (A) as a special case. suggests when (B) is likely to occur.

6. 6 Why Experiments? Do Mickey Mouse markets help us understand real stock markets? Advantages of Experiments 1) Control Environments Powerful tests of hypotheses 2) Avoid Joint-Hypothesis Problem

7. 7 Fundamental Value vs. Price for a simple, single dividend security Fundamental value: Long-term Investors Valuation: (1) (2) Short-term Investors Valuation: (3) P t is not necessarily equal to F t

8. 8 Textbooks: P t = F t Rational Expectation of P t+k Homogeneous Investors The Law of Iterated Expectations By recursive process, P t = F t is derived by the backward induction.

9. 9 Difficulty of Backward Induction Backward Induction may fail. Infinite maturity (rational bubbles) Blanchard and Watson (1982), Tirole (1985) Infinite number of trading opportunities Allen and Gorton (1993) Heterogeneous Information Froot, Scharfsten, and Stein (1992), Allen, Morris, and Shin (2002) Rationality is not common knowledge Delong et al. (1990a)(1990b), Dow and Gorton (1994)

10. 10 Price Bubble sans Dividend Anchors There are cases where short-term investors have difficulty in backward induction. Stock prices (P t ) form bubbles ( F t ) No longer anchored by future dividends

11. 11 Our Experimental Study What happens when short-term investors have difficulty in the backward induction? Two kinds of the lab markets (1) Long-term Horizon Session (2) Short-term Horizon Session Bubbles are more likely to arise in (2)?

12. 12 Long-term Horizon Session Single terminal dividend at the end of period 15. An investors time horizon is equal to the securitys maturity. Prediction: P t = D Period 1Period 15 D (Trade)

13. 13 Short-term Horizon Session Single terminal dividend at the end of period 30. The session will likely be terminated earlier. If terminated earlier, the stock is liquidated at the following period predicted price. An investors time horizon is shorter than the maturity and it is difficult to backward induct. Prediction: P t D Period 1 Period xPeriod 30 DE x (P x+1 ) (Trade)

14. 14 Subjects Assigned One of Two Roles Investors: Each endowed with 10 shares, 10,000 points in cash (US$ paid depending on earned points). Predictors: Write down the next period price predictions (US$ paid depending on the prediction accuracy) Terminal value in short-horizon sessions Price prediction data

15. 15 Trading Screen Caplab system installed into Yale SOM lab room

16. 16 Conducted Experiments Yale university, Sep. 2001 – Jul. 2002 Subjects: undergraduate students 5 long-horizon sessions 6 short-horizon sessions We present results from ALL experiments we conducted, including our errors

17. 17 Long-Horizon Sessions Sessions 3, 4, 5, 6, 7

18. 18 Result 1 In the long-horizon sessions, security prices converge to the fundamental values.

19. 19 Figure 3: Stock Prices and Efficiency of Allocations for Session 3 (Exogenous Terminal Payoff Session) Figure 3: Stock Prices and Efficiency of Allocations for Session 3 (Exogenous Terminal Payoff Session)

20. 20 Figure 4: Stock Prices and Efficiency of Allocations for Session 4 (Exogenous Terminal Payoff Session)

21. 21 Figure 5: Stock Prices and Efficiency of Allocations for Session 5 (Exogenous Terminal Payoff Session)

22. 22 Figure 6: Stock Prices for Session 6 (Exogenous Terminal Payoff Session)

23. 23 Figure 7: Stock Prices and Efficiency of Allocations for Session 7 (Exogenous Terminal Payoff Session)

24. 24 Discussion (long-horizon sessions) Long-horizon Investors play a crucial role in assuring efficient pricing. Their arbitrage brings prices to the fundamentals. Speculative trades do not seem to destabilize prices. 39.0% of transactions were speculative trades.

25. 25 Short-Horizon Sessions Sessions 1, 2, 8, 9, 10, 11

26. 26 Result 2 In the short-horizon sessions, the security prices deviate from the fundamental values to form bubbles.

27. 27 Figure 8: Stock Prices and Efficiency of Allocations for Session 1 (Endogenous Terminal Payoff Session)

28. 28 Figure 9: Stock Prices and Efficiency of Allocations for Session 2 (Endogenous Terminal Payoff Session)

29. 29 Figure 10: Stock Prices and Efficiency of Allocations for Session 8 (Endogenous Terminal Payoff Session)

30. 30 Figure 11: Stock Prices and Efficiency of Allocations for Session 9 (Endogenous Terminal Payoff Session)

31. 31 Figure 12: Stock Prices for Session 10 (Endogenous Terminal Payoff Session)

32. 32 Figure 13: Stock Prices for Session 11 (Endogenous Terminal Payoff Session)

33. 33 Discussion (short-horizon sessions) Price levels and paths are indeterminate. Level Small Bubble (Session 1) Large Bubble (2, 8, 9, 10) Negative Bubble (11) Path Stable Bubble (1, 11, 2 ?) Rational Bubble Growing Bubble (8, 9, 10) Amplification Mechanism, Positive Feedback

34. 34 Result 3 In the long-horizon sessions, price expectations are consistent with backward induction. In the short-horizon sessions, price expectations are consistent with forward induction.

35. 35 Models of Expectations Backward induction (Fundamental) Model: 0 < 1: Forward induction (1): Adaptive model, 0 < 1: Forward induction (2): Trend model, 0 :

36. 36 Price Expectation Model Estimates: Long-Horizon Sessions Dependent Variable: E t (P t+1 ) - P t

37. 37 Price Expectation Model Estimates: Short-Horizon Sessions Dependent Variable: E t (P t+1 ) - P t

38. 38 Discussion (Price Expectation) In long-horizon sessions, future price expectations are formed by fundamentals. Speculation stabilizes prices. In short-term sessions, future price expectations are formed by their own or actual prices. Speculation may destabilize prices.

39. 39 Results 4 and 5 4. Allocative efficiency is high in the long- horizon sessions, and unpredictable in the short-horizon sessions. 5. The cross-sectional dispersion of investor wealth increases with the size of bubbles.

40. 40 Figure 12: Dispersion of Investor Profits

41. 41 Conclusion Investors short-term horizons, and the attendant difficulty of the backward induction, tends to give rise to price bubbles. Prices lose dividend anchors and become indeterminate. Future price expectations are formed by forward induction.

42. 42 Implications (1) Bubbles are known to occur more often in markets for securities with (i) longer maturity and duration (ii) higher uncertainty Consistent with our lab observations. Inputs to expectation formation matter: Dividend policy matters! Accounting reports matter!

43. 43 Implications (2) Ex post, market inefficiency, anomalies, and behavioral phenomena more likely to be observed in markets dominated by short-horizon investors (difficulty of backward induction) Ex ante, it is difficult to define them, because we do not know the fundamental values

44. 44 Thank You The paper and the presentation available at http://www.som.yale.edu/faculty/Sunder/ hirotasunderpublished.pdf Please send your comments to shyam.sunder@yale.edu