New York Fed finds amateur investors create market bubbles

A new study from the New York Fed finds that when amateurs drive a market bubbles develop.

Why it matters: Given the rising number of inexperienced retail traders who have taken to investing this year, the study's findings could have obvious implications for the current state of U.S. financial markets.

What happened: Researchers at the central bank designed an experiment featuring trained stock traders and untrained students to see how they would respond to a controlled experiment in which both groups attempt to value assets.

What they're saying: "We find three differences between traders and students:

• "Traders do not generate the price bubbles observed in previous studies with student subjects."
• "Traders aggregate private information better."
• "Traders show higher levels of strategic sophistication in the Guessing Game."

What it means: "Rather than reflecting differences in cognitive abilities or other individual characteristics, these results point to the impact of traders’ on-the-job learning and traders’ beliefs about their peers’ strategic sophistication."

Zoom in: "Traders were better at understanding the repetitive feedback loop that comes when you try to predict the actions of other people who are also trying to predict crowd behavior," DataTrek Research co-founder Nicholas Colas notes. "Students largely failed to understand this dynamic."

Be smart: Another important point from Colas, who highlighted the study in his morning note: "The fact that the rookies create asset price bubbles in the middle (not at the start) of their involvement is intriguing, and other studies agree on this fact."

• "Since you only know where 'the middle' might be once you’re well past it, this is exactly why trading bubbles in real time is so difficult."