In these uncertain economic times, we’d all like a guaranteed investment. Here’s one: it pays a 24-cent dividend every four weeks for 60 weeks, 15 dividends in all. Then it disappears. Unlike a bond, this security has no redemption value. It simply provides guaranteed dividends. It involves no tricky derivatives or unknown risks. And it carries absolutely no danger of default. What would you pay for it?
Before financially sophisticated readers drag out their calculators, look up interest rates, and compute the present value of those future payments, I have a confession to make. You can’t buy this security, and it doesn’t really pay dividends every four weeks. It pays every four minutes, in a computer lab, to volunteers in economic experiments.
For more than two decades, economists have been running versions of the same experiment. They take a bunch of volunteers, usually undergraduates but sometimes businesspeople or graduate students; divide them into experimental groups of roughly a dozen; give each person money and shares to trade with; and pay dividends of 24 cents at the end of each of 15 rounds, each lasting a few minutes. (Sometimes the 24 cents is a flat amount; more often there’s an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24 cents.) All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens, repeating the same experiment with different small groups to get a larger picture.
The great thing about a laboratory experiment is that you can control the environment. Wall Street securities carry uncertainties—more, lately, than many people expected—but this experimental security is a sure thing. “The fundamental value is unambiguously defined,” says the economist Charles Noussair, a professor at Tilburg University, in the Netherlands, who has run many of these experiments. “It’s the expected value of the future dividend stream at any given time”: 15 times 24 cents, or $3.60 at the end of the first round; 14 times 24 cents, or $3.36 at the end of the second; $3.12 at the end of the third; and so on down to zero. Participants don’t even have to do the math. They can see the total expected dividends on their computer screens.
Here, finally, is a security with security—no doubt about its true value, no hidden risks, no crazy ups and downs, no bubbles and panics. The trading price should stick close to the expected value.
At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, Noussair emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.
So much for security.
These lab results should give pause not only to people who believe in efficient markets, but also to those who think we can banish bubbles simply by curbing corruption and imposing more regulation. Asset markets, it seems, suffer from irrepressible effervescence. Bubbles happen, even in the most controlled conditions.
Experimental bubbles are particularly surprising because in laboratory markets that mimic the production of goods and services, prices rise and fall as economic theory predicts, reaching a neat equilibrium where supply meets demand. But like real-world purchasers of haircuts or refrigerators, buyers in those markets need to know only how much they themselves value the good. If the price is less than the value to you, you buy. If not, you don’t, and vice versa for sellers.
Financial assets, whether in the lab or the real world, are trickier to judge: Can I flip this security to a buyer who will pay more than I think it’s worth? In an experimental market, where the value of the security is clearly specified, “worth” shouldn’t vary with taste, cash needs, or risk calculations. Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But—here’s the wrinkle—you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn’t matter that we know the security is worth $3.12. For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.” That’s rarely the case. Rather, “if you put people in asset markets, the first thing they do is not try to figure out the fundamental value. They try to buy low and sell high.” That speculation creates a bubble.