Investor emotions and stock market bubbles
In the late 1990s, investor emotion played a significant role in inflating the dot-com bubble, which, ultimately, burst. Now new research shows that emotional excitement inflates and extends such bubbles.
The research, “Bubbling with Excitement: An Experiment,” forthcoming in the Review of Finance, is co-authored by Finance Prof. Terrance Odean of the Haas Finance Group, with two others.
Their experiment compared investor behavior under three emotional states that varied in both intensity and polarity: excitement (high intensity and positive), calm (low intensity and positive), and fear (high intensity and negative).
Each experiment gave nine participants an allotment of cash and shares of a fictional asset to trade.
After three practice rounds of trading, each participant watched a video selected to induce one of the three desired emotional states. After 15 rounds of trading, participants experiencing positive emotions—for example, those who watched action films—were more aggressive, pushing prices up until the final rounds. Those who watched scary movies proceeded more cautiously.
Odean says the research increases our understanding of how bubbles work. “When investors are excited, they are more likely to engage in uncritical buying and drive prices up. Rising prices, in turn, increase excitement,” he says. “In the real world, inflated prices are not a good thing, since bubbles eventually burst.”