Why Markets Form Bubbles and Odd Short Term Blips
H/T Victor Ricciardi
What is the mechanism that determines market prices of financial assets? The literature of modern finance theory brought out models in order to propose an answer to this question. These models presume that all market participants act strictly rationally. With this very restrictive assumption, modern finance models fail to explain short term phenomena, like temporary deviations of the asset price from the fundamental value of the asset, e.g. speculative bubbles, referred as the equity puzzle in this paper. The upcoming literature of behavioural finance theory loosens the restrictive assumptions of modern finance theory in favour of the acceptance of an investor’s irrationality. Many efforts have been undertaken so far to solve the equity puzzle by the aid of the various aspects from behavioural finance.
The purpose of this paper is also attempting to explain the phenomena of the equity puzzle, however the integrated asset pricing model provided here is quite different compared to former approaches. The aspects from behavioural finance can be differentiated into psychological and sociological aspects. Special attention is dedicated to the behavioural aspects from sociology, as social interaction between the investors is a mechanism that can either reduce or amplify the likelihood of the occurrence of abnormal phenomena in the sense of modern finance theory.