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Why financial markets misprice fundamental value

Experimental research has produced robust evidence for mispricing of assets relative to their fundamental values even with active trading and sufficient information. Academic studies support a wide range of causes for such mispricing, including asset supply, peer performance pressure, overconfidence in private information, speculative overpricing, risk aversion, confusion about macroeconomic signals and – more generally – inexperience and cognitive limitations of market participants.

Powell, Owen and Natalia Shestakova (2017), “The robustness of mispricing results in experimental asset markets”.
with quotes from a range of other papers summarized at the bottom of the post.

The post ties in with SRSV’s lecture on macro information efficiency, particularly the section on why financial markets are not information efficient.
The below are excerpts from the paper and from a set of related studies. Emphasis and cursive text have been added.

The mispricing phenomenon

“One important property of markets that has received considerable attention is mispricing. Mispricing refers to the extent to which prices in a market might deviate from underlying fundamental values…Since fundamental values are typically not observed…it is common to study mispricing in experiments.” [Powell and Shestakova]

“We define an experimental asset market as a market in which [1] participants trade two assets for one another, [2] participants receive an endowment of the assets…[3] assets generate the same returns to all participants, [4] all participants have the same information about the returns, and [5] exchange takes place in a controlled experimental setting…The fundamental value is the ratio of the expected returns to holding a single unit of each of the assets A and B from now until the end of the market. It represents a rate of exchange between the two assets that rules out arbitrage possibilities.” [Powell and Shestakova]

“The tendency for experimental markets for long-lived assets to price at levels that differ from intrinsic values is one of the most robust and puzzling results from research in experimental markets. This result…has been replicated in numerous studies, though the extent and pattern of mispricing is affected by a number of factors. These include the levels of endowment of shares and cash available for transactions, the trading institutions employed, whether margin buying, short-selling, or futures trading is permitted, the training of subjects, and the induction of emotions.” [Breaban and Noussair]

Causes and conditions of mispricing

Relative asset supply is an important determinant of prices. In particular, assets that are in relatively high (low) supply tend to be under- (over-) priced…This supports the downward-sloping demand hypothesis: the larger the supply of an asset, the lower its valuation.” [Powell and Shestakova]

“Markets with constant fundamentals exhibit much lower absolute mispricing compared to markets with non-constant fundamentals.” [Powell and Shestakova]

“Several studies show that mispricing decreases with repetition of the market environment. The standard way to measure experience in the literature is the average number of markets that a trader had previously participated in within the same study.” [Powell and Shestakova]

“One of the most striking results from experimental asset markets is the tendency of asset prices to bubble above fundamentals and subsequently crash,,,When margin buying is allowed and short selling is prohibited price bubbles are observed for…assets and are larger for the lottery asset [with low-probability large upside potential] than the standard asset.” [Ackert, Charupat, Church and Deaves]

“Relative performance is a particularly important motivation for professional investors since it has a large impact on the ability to increase funds under management…A large literature has demonstrated that inexperienced traders…typically generate a bubble-like pattern in asset prices, which begin below expected value and then exceed expected value for much of the experiment before collapsing near the end. This pattern is robust to a wide variety of manipulations… In the present study, we examine whether concerns with relative performance are present in experimental markets even in the absence of direct monetary tournament incentives… We demonstrate that the reference outcome affects traders’ reported subjective utility for their monetary outcome from the experiment in a manner consistent with the existence of tournament incentives. We also show that the type of relative performance information provided has a significant effect on market prices: average trading prices are higher, the peak deviation of trading price from fundamental value is higher, and there are more periods when trading prices are higher than fundamental value in markets where all participants observe the highest Account Total.” [Schoenberg and Haruvy]

“The concept of overconfidence is based on the large body of evidence from research in cognitive psychology, which suggests that human-beings overestimate their own knowledge…Overconfidence is usually modeled as overestimation of the precision of private information and results in underestimation of the variance of asset prices. Well known results in this framework are that overconfidence causes excess trading volume and excess price volatility, as well as the occurrence of the speculative price bubbles…Main findings from our experiment can be summarized as follows. Higher market overconfidence is accompanied by the higher average market prices and larger deviations of prices from fundamental value…Moreover, bubble and burst patterns were observed in overconfident markets… Volatility of the prices and trade volume proved to be significantly lower in the rational markets.” [Michailova and Schmidt]

“Speculative overpricing [is]…the phenomenon where the current price of an asset exceeds the maximum amount any trader is willing to pay if he/she has to hold the asset to maturity. Traders are willing to ‘overpay’ in equilibrium because they believe (correctly) that in equilibrium there is a chance that another trader will value the asset more highly than they do at some future date. The key insight…is that speculative overpricing of a multiperiod asset can arise in equilibrium if there is a combination of the short-sale constraint and divergent beliefs about the fundamentals determining the underlying value of the asset.” [Palfrey and Wang]

“Our research question is the following: do the risk aversion, loss aversion, and cognitive ability level of participants, correlate with market-and individual-level behavior? To consider this we obtain direct measures of risk aversion, loss aversion, and cognitive ability from our subjects before they participate in the market… Greater average risk aversion on the part of traders in the market predicts lower market prices. The greater the level of loss aversion of the trader cohort, the lower the quantity traded. The greater the average cognitive reflection test score, the smaller the differences between market prices and fundamental values.” [Breaban and Noussair]

“We subject a laboratory asset market to an exogenous shock, which either inflates or deflates the nominal fundamental value of the asset while holding the real fundamental value constant. After an inflationary shock, nominal prices adjust upward rapidly, and we observe no real effects. However, after a deflationary shock, nominal prices display considerable inertia and real prices adjust only slowly and incompletely toward the levels that would prevail in the absence of a shock. Thus, an asymmetry is observed in the price response to inflationary and deflationary nominal shocks.” [Noussair, Richter and Tyran]

Robustness of academic findings

“Many experiments have been conducted on market mispricing… we investigate the robustness of previous results with respect to four variations: the choice of interval length, the use of the bid-ask spread as a price proxy, the choice of aggregation function, and controlling for observable market characteristics… We consider peer-reviewed publications from 2005-2015 that satisfy our inclusion criteria (48 studies)… Our results are of the ‘glass half-full, glass half-emtpy’ genre. On the one hand, it is reassuring that a majority of results (71.5%) do not change significance under the new procedure. However, this still leaves a substantial minority (28.5%) that are affected. We think this suggests the need to further discuss and examine the sensitivity of experimental asset market research.” [Powell and Shestakova]

Additional sources

Ackert, L. F., Charupat, N., Church, B. K., and Deaves, R. (2006). “Margin, short selling, and lotteries in experimental asset markets”. Southern Economic Journal, 73(2).

Breaban, A. and Noussair, C. N. (2015). “Trader characteristics and fundamental value trajectories in an asset market experiment”. Journal of Behavioral and Experimental Finance, 8:

Michailova, J and U Schmidt (2011). “Overconfidence and Bubbles in Experimental Asset Markets”, Kiel Working Paper No. 1729, September 2011.

Noussair, C. N., Richter, G., and Tyran, J.-R. (2012). “Money illusion and nominal inertia in experimental asset markets”. Journal of Behavioral Finance, 13(1).

Palfrey, T. R. and Wang, S. W. (2012). “Speculative overpricing in asset markets with information flows”. Econometrica, 80(5).

Schoenberg, E. J. and Haruvy, E. (2012). “Relative performance information in asset markets: An experimental approach”. Journal of Economic Psychology, 33(6).


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