Informed traders, beauty contest and stock price volatility: Evidence from laboratory markets

Abstract

Whether informed investors (e.g., professionals) trade stocks based on the fundamentals or ride on market sentiment is an empirical question, but few attempts have been made due to the lack of field data. We, therefore, conduct a laboratory experiment and examine if informed investors trade stocks based on their anticipation of less‐informed investors' valuation. In our experimental market, informed traders know the fundamental value of the stock; less‐informed traders do not know the accurate value and their valuation may be biased upwards or downwards. We find that informed traders ride on the (mis)valuations of less‐informed traders, and the speculative trades of the informed traders significantly affect stock prices. Our experimental result explains why stock prices are subject to the mass psychology sentiment even in markets with informed investors.