Crowd psychology: Market movements and speculative bubbles.

Rising black business bull in color background

The evolution of stock prices is the result of macroeconomic (rate hikes, intergovernmental negotiations,…) and microeconomic (quarterly declarations, patents,…) events. If we follow this logic, it seems easy to predict price movements based on these elements, yet there are great uncertainties in the evolution of stock market prices. These uncertainties concern both the financial health of companies and the reactions of investors on the market.

In its 1986 article “Noise”, Black defines market movements as being composed of two aspects, one fully understood and quantified, while the second defines noise as being full of uncertainty. If we try to measure these market movements from the point of view of financial actors, the noise defined by Black would correspond to the share of irrational investors, whose positions are outside the financial logic. The development of these investors leads stock exchange prices to disconnect from the economic value of companies.

What leads some investors to develop irrational behaviour ?

The investor is often defined as rational when he aims to maximize his return, by obtaining the best investment opportunities, while minimizing his risk exposure. Many biases are observed in the decision-making process, due to the highly uncertain financial universe.

Among these biases we can note the heuristic behavior to which many investors are exposed, when they have to make quick decisions in this uncertain universe. Let’s take the case of some managers who open positions in a sector because they have an impact on the sector. Their decision, which will not be based on a thorough analysis of returns and risks in the sector, will feed into the many other decisions not taken rationally by other investors.

Another bias that has a strong impact on stock market prices has been highlighted by André Orléan, namely market mimetism. Orléan explains in his 2001 article that market mimicry can take 3 forms:

  • Informational mimicry: the more recurrent the investor sees the same type of information appear about an event, the more likely he or she thinks that the event is likely to occur. This leads investors to buy the shares of the companies they hear most about. They believe that other investors who are interested in these shares and who buy them have additional information that allows them to get ahead of the curve.

  • Reputation mimicry: Some investors for fear of making mistakes will take a similar position to the majority of investors in the market. The investor with information that is contradictory to that of common thought will abandon this information, preferring to make a mistake with the group and share the fault, rather than be alone in taking the blame.

  • Self-referential mimicry: The investor believes that the price given by the market is the right price, that of the dominant opinion on the market. Regardless of the results provided by analysts, only market interpretation matters. This type of mimicry leads to a strong disconnect between the economic value of companies and stock prices during periods of stress.

This bias allows us to evoke the subject of speculative bubbles under a behavioural aspect.

Psychological aspects of speculative bubble formation:

The market is a highly connected community, investors follow their own movements by measuring those of others, with a contagion of behaviours that appears during periods of stress that sometimes leads to euphoria in periods of increase.

Kindleberger explains euphoria as the progressive diffusion of speculative behaviour to ordinary investors, who do not usually engage in such practices but who respond to a desire for quick gains. Investors buy at a price higher than the fundamental value, for the sole purpose of selling at an even higher price, but in the long term the fundamental value prevails, the prices end up being corrected.

At the beginning of its formation, the bubble is not one. Prices increase as investors holding the information take a position in anticipation of future growth potential. Then, as time goes by, the “outsider” investors, who take a position by imitating the first ones in order to benefit from the rise in prices. At this point, it makes perfect sense for them to copy, because the first investors know more than they do. A third wave of investors will imitate the second who were imitators of the first, the situation becomes irrational. The latest arrivals think that those they imitate (outsiders) have privileged information, which is false.

These successive imitations will accentuate the dynamics of increase, which will itself lead to new waves of imitations. Some investors who are fully aware of the disconnection of the price from the fundamental value buy to take advantage of the upward movement, without taking into account the doubts they have about the continuity of the dynamics.

The situation eventually changes when stress is at its peak and investors begin to distrust each other’s behaviour, all that is needed is a public announcement in the direction of fears and it is the bursting of the bubble.

Sources :

“Understanding speculative crowds: Information, self-referential and normative mimicry” – A. Orléan – 2001

” Manias, Panics, and Crashes – A History of Financial Crises ” – C. Kindleberger – 2000

” Noise ” – F.Black – 1986

Abdoulaye DIALLO

Abdoulaye DIALLO

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