Stock Market Crashes and Rational Expectation

Manila Bulletin, July 9, 2006 | Go to article overview

Stock Market Crashes and Rational Expectation


Byline: Jovito Vernon S. Valente San Beda College

CRITICS of market efficiency argue that there are several instances of recent market history where market prices could not plausibly have been set by rational investors and that psychological considerations must have played the dominant role. It is alleged, for example that the stock market lost about one-third of its value from early to mid-October, 1987 with essentially no change in the general economic environment. How could market prices be efficient both at the start of October and during the middle of the month? Similarly, it is widely believed that the pricing of Internet stocks in early 2000 could only be explained by the behavior of irrational investors. Do such events make a belief in efficient markets untenable?

Can the October, 1987 market crash be explained by rational circumstances, or does such a rapid and significant change in market valuations prove the dominance of psychological rather than logical factors in understanding the stock market? Behaviorist would say that one-third drop in market prices, which occurred early in October 1987, can only be explained by relying on psychological considerations, since the basic elements of valuation equation did not change rapidly over that rapid. It is, of course, impossible to rule out the existence of behavioral or psychological influences on stock market pricing. But logical consideration can explain a sharp change in market valuations such as occurred during the first weeks of October, 1987.

In the hope of helping to avoid encasing life savings in the next bubble or contributing to the next crash, the researcher is looking at the creme de la creme of crashes as a cautionary tale.

Knowing Stock Market Bubbles and Stock Market Crash

We find that irrational bubbles continue to form in an experimental assets market even though experience lessens spacious market pricing. However, this irrationality may remain hidden from the customary observational perspective. Both price expectations and bubbles appear rational, passing both traditional and co-integrational tests. Conventional statistical testing has difficulty distinguishing "irrational" inertia from "rational" market behavior. Yet, inertia provides a much better explanation of observed, experimental market prices than do the "fundamentals."

Conventional economics assumes that investors possess all the necessary information to buy and sell assets in an efficient and rational manner. "Rational" expectation theory requires that investors behave as if they know the actual mechanism which determines prices and can forecast market prices unbiasedly. Although it is widely accepted that such knowledge is denied more mortals, these assumptions remain an essential component of orthodox economic theory and policy advice. After all, "maximization-of-returns" would make little sense unless agents "had full knowledge of the data needed to succeed in this attempt" (Friedman, 1953, p.21).

A "bubble" is a type of investing phenomenon that demonstrates the frailty of some facets of human emotion. A bubble occurs when investors put so much demand on a stock that they drive the price beyond any accurate or rational reflection of its actual worth, which should be determined by the performance of the underlying company. Like the soap bubbles a child likes to blow, investing bubbles often appear as though they will rise forever, but since they are not formed from anything substantial, they eventually pop. And when they do, the money that was invested into them dissipates into the wind.

A "crash" is a significant drop in the total value of a market, almost undoubtedly attributable to the popping of a bubble, creating situation wherein the majority of investors are trying to flee the market at the same time and consequently incurring massive losses. Attempting to avoid more losses, investors during a crash are panic selling, hoping to unload their declining stocks onto other investors. …

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