Why Short-Term Investor Horizons Can Create Stock Market Bubbles

C. Carrera
Aug 11
3 min read

While reading a number of papers this weekend, including Morgan Stanley’s latest whitepaper, The Wisdom of Crowds in Markets: Crowd Behavior in Prediction, Betting, and Stock Markets, I came across a 2008 study that I wanted to explore further.

The study, Price Bubbles Sans Dividend Anchors: Evidence from Laboratory Stock Markets, by Shinichi Hirota and Shyam Sunder of Yale University, asks a simple question:

Why do stock prices sometimes inflate into bubbles, disconnected from what the stock is actually worth?

Rather than approaching the question purely theoretically, the researchers ran controlled laboratory experiments in which participants traded a simulated stock. Their objective was to understand the conditions under which bubbles form.

The core idea: what anchors a stock’s value?

The study starts from the idea that a stock’s fundamental value comes from the dividends it will eventually pay to shareholders. Today, this should be adapted to include all returns to shareholders, including share buybacks, which have become increasingly common over the past two decades.

If investors operate with a long-term horizon, they can work backward from those eventual shareholder returns to estimate what the stock should be worth today.

This process is known as backward induction.

When investors can reason all the way back from the eventual payout, prices should remain closely anchored to fundamental value.

What changes when investors focus on the short term?

The situation changes when investors have shorter time horizons.

If traders cannot be confident that they will still own the stock when its eventual payout occurs, they cannot rely as easily on that final payout to determine what the stock is worth today.

Instead, they begin forming expectations based on recent prices and price trends.

As that happens, prices can lose their fundamental anchor and begin to move away from the underlying value of the security. That is where bubbles can form.

How the experiment worked

The researchers created two types of trading sessions.

Long-horizon sessions

Participants’ investment horizon matched the full lifespan of the security.

They therefore had the ability to reason all the way through to the final dividend payment.

Short-horizon sessions

The market could end before the security reached its final payout.

Participants therefore faced a shorter effective investment horizon and could not reliably work backward from the eventual dividend. The researchers then observed how prices behaved under the two conditions.

What happened with long-horizon investors?

In the long-horizon sessions, prices converged closely toward fundamental value.

Investors formed expectations by working backward from the eventual dividend.

Importantly, speculation did not destabilize prices.

Instead, speculation helped bring prices toward their fundamental value.

What happened with short-horizon investors?

The short-horizon sessions produced a very different result. Prices became disconnected from fundamental value and bubbles formed. Some bubbles were small. Some were large. And some were even negative. Rather than anchoring their expectations to the eventual dividend, investors increasingly based their expectations on recent and expected price movements. This created a mechanism through which price movements could reinforce further price movements, allowing bubbles to develop.

The study also found that the dispersion of investor wealth increased as the size of the bubbles increased.

The conclusion

The study offers an interesting explanation for why bubbles form. Bubbles are not simply the result of irrational behaviour or an inherent characteristic of long-lived securities. They can arise when investors have short time horizons and are unable to confidently reason backward from a security’s eventual payout. When investors have a sufficiently long horizon, prices remain anchored to fundamentals. When their horizon becomes shorter, attention can shift from underlying value toward expectations about future market prices. And once that happens, prices can begin to detach from fundamental value.