How Naive Investors Can Create Bubbles
How Naive Investors Can Create Bubbles
In Brief While tech stocks are a big driver of economic growth, many investors do not know how to evaluate the potential of startups using a new technology.
Why This Matters Throughout history, naive investors have often helped create bubbles, which can be disastrous for the economy as a whole.
The Takeaway Investor education can significantly reduce the likelihood of bubbles. All investors need to do is to follow a few simple guidelines.
With the advent of online trading, more Americans are investing in stocks than ever before. While nearly all economists agree that the so-called “democratization of the market” is a positive development, there’s also a potential downside. “Today we also have many more investors who do not understand how technological innovation creates value, and our research shows that throughout history, naive investors have been a key factor in creating bubbles,” says Brent Goldfarb, an Associate Professor of Management and Entrepreneurship at the University of Maryland’s Robert H. Smith School of Business.
Along with his co-author David A. Kirsch, also an Associate Professor of Management and Entrepreneurship at the Smith School, Goldfarb has just completed a book, Bubbles and Crashes: The Boom and Bust of Technological Innovation, which Stanford University Press published in early February. Goldfarb and Kirsch define a bubble as a “rise and fall in asset prices such that prices deviate from fundamental or intrinsic value.” And unfortunately, a bubble—say, the stock market bubble of 1929—has the potential to take the whole economy down with it.
Goldfarb and Kirsch got the idea for Bubbles and Crashes about ten years ago when they were working on an academic paper on the dot.com bubble. “We realized that we couldn’t really talk about what causes a bubble by looking at a single bubble,” says Kirsch. “Bubbles are associated with technological innovations, but sometimes there is a bubble and sometimes there is a non-bubble.” So they decided to do a deep dive into American history—to see why certain technological innovations led to bubbles and others did not.
Based on an examination of eighty-eight technological innovations over a 150-year period, the book fleshes out a theoretical explanation for why bubbles happen. The participation of many naive investors is just one of the four key ingredients; the three others are a lot of uncertainty about the technological innovation, the prevalence of what Goldfarb and Kirsch call “pure-plays”—firms that make use of the new technology that investors can easily buy and sell shares in—and the existence of “story”—the narrative pitch that companies using a new technology craft in order to gin up interest.
Take the case of commercial aviation. A bubble developed soon after Charles Lindbergh’s 1927 solo flight across the Atlantic. “There was tremendous enthusiasm in aviation by the late 1920s,” says Goldfarb, “but it would not be until the early 1950s and the development of the jet engine that companies were sufficiently profitable to justify the 1920s stock prices.”
While Goldfarb and Kirsch worry about the potential impact of today’s naive investors, they believe this is a problem that could easily be solved. In a concluding chapter in which they offer policy prescriptions, they highlight the benefits of investor education. If all investors followed a few simple guidelines, they argue, the likelihood of future bubbles would go down significantly. “One important thing that investors need to keep in mind is that if they happen to like a new technology, that does not mean that companies using that technology are going to be successful. So if you are a satisfied Tesla owner, you should not necessarily invest in Tesla,” says Goldfarb.
Another tip that Goldfarb and Kirsch offer is the need to understand that new technology should provide a practical solution to a real-world problem. “While crypto-currencies such as Bitcoin have a lot of promise, it may be a long time before consumers can rely on it to buy a cup of coffee,” Goldfarb says. They also encourage investors to become better readers of “story.” “With bitcoin, investors need to think through how this is going to play out down the road. What else has to happen before companies can make a profit?” Finally, Goldfarb and Kirsch also make the case for a healthy dose of skepticism toward the advice of all experts. “Investors need to take every expert’s statement with a grain of salt,” says Goldfarb. “With new technologies, nobody really knows anything for sure.”
Joshua Kendall has written on business and healthcare for numerous publications including BusinessWeek, Fortune.com, The New York Times, The Boston Globe and The Washington Post. For more about his work visit JoshuaCKendall.com.