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Emotional excitement not only creates stock market bubbles but, new research shows, the frenzy actually causes them to grow.
In the late 1990s, investor emotion played a significant role in inflating the dot-com bubble and ultimately, making a lot of people rich.
"We observed a lot of excitement in conjunction with real-world events such as the dot-com bubble and 'tulip mania' in 1637 and we wanted to see if people's high arousal would increase the size of the bubble," said professor Terrance Odean from University of California Berkeley.
For the study, participants' emotions were stimulated by making them watch popular action films such as "Mr. and Mrs. Smith" with Brad Pitt and Angelina Jolie playing married assassins, prior to making buying or selling stocks.
The experiment involving 495 participants compared investor behaviour under three emotional states that varied in both intensity and whether they were positive or negative: excitement (high intensity and positive), calm (low intensity and positive), and fear (high intensity and negative).
After three practice rounds of trading, each participant watched a video selected to induce one of the three desired emotional states.
Next, they answered two short questions about their emotional state before proceeding to 15 rounds of trading.
Participants who experienced intense positive emotions while watching action films prior to trading were more aggressive, pushing prices up until the final rounds.
Those who watched scary movies proceeded more cautiously.
The research increases our understanding of how bubbles work.
"As asset prices went up and investors got excited, they were more likely to do uncritical buying and drive prices up more," Odean said.
In the real world, triggers for excitement could also lead to inflated prices, which is not necessarily a good thing when the bubble can burst, he noted.
The study is forthcoming in the journal Review of Finance.
