There is an older literature for sure, but it was largely dismissed during the heyday of the rational expectations revolution in the 1970s and 1980s. The first break was the presidential speech to the American Finance Association in 1985 by Fischer Black, pubbed in 1986 in the Journal of Finance as “Noise,” followed by the 1987 stock market crash, and then a pair of rigorous papers in 1990 and 1991 in the QJE and Journal of Business by the formidable quartet of Bradford DeLong, Andrei Shleifer, Lawrence Summers, and Robert Waldmann. They in particular argued that a rational trader must take into account the beliefs and actions of the noise traders, which can then get one into the realm of the old problem, going back to Keynes, of self-fulfilling prophecies. The issue is not false beliefs, it is understanding that the market may be driven by people who are not following long-run fundamentals and taking accurate advantage of their behavior. It is a matter of accurately forecasting a market, in the case of a bubble, accurately forecasting the path of the bubble, and those who do so can and will make more money than the safe, fundamentalist trader who stays away from the bubble.
Douglas Knight,
There is an older literature for sure, but it was largely dismissed during the heyday of the rational expectations revolution in the 1970s and 1980s. The first break was the presidential speech to the American Finance Association in 1985 by Fischer Black, pubbed in 1986 in the Journal of Finance as “Noise,” followed by the 1987 stock market crash, and then a pair of rigorous papers in 1990 and 1991 in the QJE and Journal of Business by the formidable quartet of Bradford DeLong, Andrei Shleifer, Lawrence Summers, and Robert Waldmann. They in particular argued that a rational trader must take into account the beliefs and actions of the noise traders, which can then get one into the realm of the old problem, going back to Keynes, of self-fulfilling prophecies. The issue is not false beliefs, it is understanding that the market may be driven by people who are not following long-run fundamentals and taking accurate advantage of their behavior. It is a matter of accurately forecasting a market, in the case of a bubble, accurately forecasting the path of the bubble, and those who do so can and will make more money than the safe, fundamentalist trader who stays away from the bubble.