Unraveling stock market crashes: insights from behavioral psychology

Abstract

PurposeA novel psychology-based framework is proposed to investigate the causes of stock market crashes.Design/methodology/approachOur approach builds upon the dynamic capital mobility model, expanding it by incorporating bidirectional relationships between investor sentiment and the average stock market price level. Investor sentiment is measured in terms of jumping rates of investors’ attitudes to the stock market in our model. The role and impact of investor sentiment on the average stock market price level are further clarified across various scenarios through simulations.FindingsOur model provides a direct quantification of the influence of investor sentiment on stock market price dynamics, shedding light on an alternative mechanism contributing to stock market crashes alongside fundamental changes. Our simulation results confirm that optimistic investor sentiment can mitigate the magnitude of negative stock market price movements triggered by adverse fundamental changes. Our model also indicates that the stock market price level may exhibit higher volatility than can be attributed to fundamental changes.Research limitations/implicationsOur study only briefly touches on the origins of shifts in investor sentiment by introducing a self-fulfilling feedback loop from the average stock market price level to investor sentiment. In future research, we will identify other key factors contributing to shifts in investor sentiment and subsequently analyze their influence on investor sentiment.Practical implicationsOur findings carry practical implications for recent and future movements in the US stock market. For instance, despite the Federal Reserve’s continuous interest rate hikes since March 2022, the overall optimistic investor sentiment has helped mitigate a severe downward movement in the stock market. However, in the absence of clear indications of a loose monetary policy, a rapid shift of investor sentiment from optimism to pessimism in the US stock market could potentially lead to a historic stock market crash.Originality/valueWhile the significance of investor sentiment in shaping stock market price dynamics, particularly regarding cross-sectional variations of stock returns, is widely recognized, quantifying directly its impact on the average stock market price level has remained a persistent challenge. Only very limited literature has delved into this subject, often hindered by a lack of theoretical support or yielding inconsistent results.