JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS Vol. 44, No. 3, June 2009, pp. 719–744 COPYRIGHT 2009, MICHAEL G. FOSTER SCHOOL OF BUSINESS, UNIVERSITY OF WASHINGTON, SEATTLE, WA 98195 doi:10.1017/S0022109009990019 Probability Judgment Error and Speculation in Laboratory Asset Market Bubbles Lucy F. Ackert, Narat Charupat, Richard Deaves, and Brian D. Kluger * Abstract In 12 sessions conducted in a typical bubble-generating experimental environment, we de- sign a pair of assets that can detect both irrationality and speculative behavior. The specific form of irrationality we investigate is the probability judgment error associated with low- probability, high-payoff outcomes. Independently, we test for speculation by comparing prices of identically paying assets in multiperiod versus single-period markets. We estab- lish that aggregate irrationality measured in one dimension (probability judgment error) is associated with aggregate irrationality measured in another (bubble formation). I. Introduction Although laboratory asset markets have yielded key insights into asset pric- ing, some results are perplexing. 1 Perhaps most striking is that in one particular multiperiod market structure, price tends to bubble above risk-neutral asset value and subsequently crash. Speculation and/or irrationality have been suggested as likely bubble ingredients. This paper further investigates bubbles by designing markets for securities whose prices can be used to detect both irrational and spec- ulative behavior. The specific form of irrationality we investigate is the probability * Ackert, lackert@kennesaw.edu, Department of Economics and Finance, Coles College of Business, Kennesaw State University, 1000 Chastain Road, Kennesaw, GA 30144 and Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309; Charupat, charupat@mcmail.cis.mcmaster.ca, Deaves, deavesr@mcmaster.ca, DeGroote School of Business, McMaster University, 1280 Main Street West, Hamilton, Ontario, Canada L8S 4M4; and Kluger, brian.kluger@uc.edu, College of Business, University of Cincinnati, 2925 Campus Green Drive, Cincinnati, OH 45221. We are grateful to Stephen Brown (the editor), Bryan Church, Werner DeBondt, Thorsten Hens (the referee), Charles Noussair, Tom Reitz, Chuck Schnitzlein, and David Stolin as well as seminar participants at Groupe ESC Toulouse and the Cass Business School for helpful suggestions. We also appreciate comments from participants at the 2007 People and Money: The Human Factor in Decision-Making Conference at the Driehaus Center for Behavioral Finance at DePaul University. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Financial support provided by the Federal Reserve Bank of Atlanta and Social Sciences and Humanities Research Council of Canada is gratefully acknowledged. 1 Hundreds of laboratory markets are reported in the literature. See Davis and Holt (1993) and Kagel and Roth (1995) for introductions to this literature. 719