Psychological Aspects of Market Crashes

with the highest levels of anticipations, and high anticipations significantly
intensify the crash magnitudes regardless of the drop level.

Our results rely on the Inada conditions to obtain, although those condi-
tions alone cannot lead to a crash unless traders largely agree upon a variation
in fundamentals. The intuition is that the marginal disutility of a low con-
sumption level on a particular history, typical of Inada conditions, can be
compensated in terms of ex-ante utility by a low probability assigned to this
history by every agent. Thus in this situation, a low contingent consumption
need not be largely hedged against and a crash may not occur.

Our findings are consistent with the empirical findings above, although
our theoretical explanation differs from that in Lee (1998). Indeed, Lee
justifies crashes by information flows varying with private information, and
crashes occur as an informational cascade when enough signals of bad times
are released by traders. In contrast, we argue that crashes are driven by
financial decisions motivated by the anticipation of future albeit uncertain
variations in market fundamentals. This behavior requires a group coordina-
tion (or large agreement) about the actual state of the economy, although it
goes beyond the idea of private information as in Lee. The coordination that
we require for crashes to occur can stem from rational expectations, erratic
beliefs generated by psychological factors (see Allen et al. (2005) or Shiller,
2000) even if it incorporates as well the situation raised in Lee (1998) and
Ho and Stein (2003).

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