Psychological Aspects of Market Crashes

1 Introduction

Sudden crashes are common features of financial markets. For instance, the
1994 Peso crisis in Mexico saw lending rates rising by four hundred percent
over four months. Psychological factors are believed to play an important
role in such situations, although the actual mechanisms linking such factors
and market volatility are not yet fully explored.

This paper analyzes the sensitivity of market crashes to investors’ psychol-
ogy in a standard general equilibrium framework. Contrary to the traditional
view that market crashes are driven by large drops in aggregate endowments,
we argue from a theoretical standpoint that individual anticipations of such
drops are a necessary condition for crashes to occur, and that the magnitude
of such crashes are positively correlated with the level of individual antici-
pations. Anticipations of changes in fundamentals, driven by psychological
factors as described later or also simply by rational expectations, are shown
here to be a key explanatory factor of market volatility.

In a General Equilibrium economy with incomplete markets where no
trader is constrained in borrowing in equilibrium, we make explicit a link
between future albeit uncertain endowments drops and their anticipations
sustaining any crash level. We quantify this relationship and illustrate the
above findings through numerical simulations in the framework of Mehra and
Prescott (1985). In particular, we show that when anticipations are not high
enough then a crash may not occur as a result of a drop in endowments. We
thus establish that changes in fundamentals alone may not trigger a crash.

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