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Unformatted text preview: What causes stock market bubbles and what do you need to know about them? The 1990’s bubble and 2000 crash in the stock market along with the Nobel Prize awarded to Kahneman and Smith has with and caused an increased interest in BEHAVIORAL FINANCE, which was already one of the hottest areas in business. Two studies are of particular relevance. First, Vernon smith was asked by the SEC to try to find a way to deal with the kind of market crash that occurred in 1987. The second study is by the behavioral economist, Robert Shiller, who published a book entitled Irrational Exuberance who Irrational that explained the crash in 2000. We will go through his explanation and see if it works for the 2008 crash. Professor Schulze AEM 414 AEM Lecture 10 Your experiment replicates Vernon Smith’s experiment Initial Cash Endowment: $12.60 Initial Assets: 2 Payoff Values (equal probability) : $0, $.08, $.24, $.28, $.60 Expected (average) payoff per round for 1 asset: $.24 Present EV of holding asset for 15 rounds: $3.60 Present EV of initial assets: $7.20 EV of base portfolio: $12.60 + $7.20 = $19.80 Professor Schulze AEM 414 AEM Lecture 10 Class Results: Average of all sections--bubble with crash AEM 414 AEM Professor Schulze Lecture 10 Class Result: Section 275 bubble with crash at very end at AEM 414 AEM Professor Schulze Lecture 10 Class Results: Section 278 crash starts in middle AEM 414 AEM Professor Schulze Lecture 10 What anomalies are important in the stock market? First consider loss aversion: First loss Richard Thaler who developed behavioral finance Richard who here at Cornell argues that loss aversion keeps people from selling when they should during a real crash. Investors are reluctant to accept the loss of selling an asset that they paid a high price for at a lower price, hoping the market will get better (which it...
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