Asset prices and informed traders’ abilities: Evidence from experimental asset markets

Abstract

This study reports the results of fifteen experimental asset markets designed to investigate the effects of forecasts on market prices, traders' abilities to assess asset value, and the link between the two. Across the fifteen markets, the authors investigate alternative forecast-generating processes. In some markets the process produces an unbiased estimate of asset value and in others a biased estimate. The processes generating the biased forecasts, though, are less variable than the process generating the unbiased forecast. The authors find that, in general, periodend asset price reflects private forecasts, regardless of the forecast-generating process. Subsequently, they investigate whether traders' abilities to use forecasts differ across the forecast-generating processes. The authors find that most are able to properly use unbiased forecasts. They refer to them as smart traders. By comparison, a significant proportion is unable to properly use biased forecasts (typically traders' adjustments for bias are insufficient). Linking market outcomes and traders' abilities, the authors find that asset price appears to properly reflect unbiased forecasts as long as the market includes at least two smart informed traders who have sufficient ability to influence market outcomes. To obtain a comparable result in markets with the biased forecast, at least three smart informed traders with sufficient ability to influence market outcomes are necessary.JEL classification: D82

What affects the market's ability to adjust for optimistic forecast bias? Evidence from experimental asset markets

“…are consistent with Ackert et al (1997a), who report that in an individual setting fewer participants acquire high bias forecasts than unbiased and low bias forecasts. The mean forecast acquisitions in markets with unbiased and low bias forecasts also are consistent with Ackert et al (2004), which investigates behavior in a market setting.…”

“…Most notably, an inspection of the data from Ackert et al suggests that a few participants could adjust for high optimistic bias. Accordingly, a small subset of informed traders who are able to adjust for bias is likely sufficient for the information contained in high bias forecasts to be revealed fully in periodend price (e.g., Foster and Viswanathan, 1996;Ackert et al, 2004). We suggest that trading experience is necessary before beliefs stabilize and a subset of the market is able to adjust for high optimistic bias.…”

“…A potential explanation for the erratic price behavior observed in the markets with high bias forecasts is that not enough traders acquire the forecast, at least not enough who adjust for the bias (e.g., Ackert et al, 2004). To investigate this explanation, we conducted additional markets in which high optimistic bias forecasts are released publicly.…”

“…Individuals are willing to acquire information as long it is reasonably priced and improves their positions (Copeland 12 Ackert et al (2004) find that price adjusts for small amounts of optimistic bias in markets with inexperienced traders. A fundamental design difference between Ackert et al and the current study is that Ackert et al provide participants with the forecast history prior to the commencement of trading.…”

“…As Becker (1962) notes, market outcomes do not necessarily reflect the actions of the average trader (see also Chen and Yeh, 2002;Ackert et al, 2004;Kluger and Wyatt, 2004). Hirshleifer (2001) concludes that a model of how individuals form beliefs about market valuations is a significant missing chapter in current asset pricing theory.…”