Stock market crashes as social phase transitions

Stock market crashes are traumatic events that affect the lives of millions of people around the globe and have tremendous economic implications. Crashes are not only dramatic, but often completely unexpected. The 1987 crash, for example, was not induced by any obvious trigger. Even after the fact, it is hard to find the reason for the crash – Why did the market crash in October rather than in September or December? Why did it crash at all? To this day, we lack satisfactory answers. This paper shows that spontaneous market crashes can be explained by a ‘social phase transition’ mechanism similar to statistical mechanics phase transitions. Investors’ heterogeneity plays the role of ‘temperature’, and is key in determining the possibility and magnitude of the crash. The analysis suggests that dramatic crashes are a robust and inevitable property of financial markets. It also implies that market crashes should be preceded by an increase in price volatility, as empirically observed. Thus, market crashes, like earthquakes, are a fundamental and unavoidable part of our world. However, we can develop early warning systems that may help minimize the damage. r 2007 Elsevier B.V. All rights reserved. JEL classification: G10; D70; C0