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Booms, busts and behavioural heterogeneity in stock prices

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  • Hommes, Cars
  • in ’t Veld, Daan

Abstract

We estimate a behavioural heterogeneous agents model with boundedly rational traders who know the fundamental stock price, but disagree about the persistence of deviations from the fundamental. Some agents (fundamentalists) believe in mean-reversion of stock prices, while others (chartists) expect a continuation of the trend. Agents gradually switch between the two rules, based upon their relative performance, leading to self-reinforcing regimes of mean-reversion and trend-following. For the fundamental benchmark price we use two well-known models, the Gordon model with a constant risk premium and the Campbell-Cochrane consumption-habit model with a time-varying risk premium. We estimate a two-type switching model using U.S. stock prices until 2016Q4. The estimations show an improvement over representative agent models that is both statistically and economically significant. Our model suggests that behavioural regime switching strongly amplifies booms and busts, in particular, the dot-com bubble and the financial crisis in 2008.

Suggested Citation

  • Hommes, Cars & in ’t Veld, Daan, 2017. "Booms, busts and behavioural heterogeneity in stock prices," Journal of Economic Dynamics and Control, Elsevier, vol. 80(C), pages 101-124.
    • Handle: RePEc:eee:dyncon:v:80:y:2017:i:c:p:101-124
    DOI: 10.1016/j.jedc.2017.05.006
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    More about this item

    Keywords

    Behavioural finance; Bounded rationality; Heterogeneous expectations; Stock prices; Financial crisis;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G01 - Financial Economics - - General - - - Financial Crises

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