We introduce diagnostic expectations into a standard setting of price formation in which investors learn about the fundamental value of an asset and trade it. We study the interaction of diagnostic expectations with two well-known mechanisms: learning from prices and speculation (buying for resale). With diagnostic (but not with rational) expectations, these mechanisms lead to price paths exhibiting three phases: initial underreaction, followed by overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a byproduct of fast moving beliefs about fundamentals, which lasts only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.
Gennaioli thanks the European Research Council (GA 647782) for financial support. We are grateful to Nicholas Barberis, Lawrence Jin, Josh Schwartzstein, and Alp Simsek for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Pedro Bordalo & Nicola Gennaioli & Spencer Yongwook Kwon & Andrei Shleifer, 2020. "Diagnostic Bubbles," Journal of Financial Economics, .