19 Feb 2007  Research & Ideas

Inexperienced Investors and Market Bubbles

The evidence isn't conclusive, but new research from Harvard Business School suggests younger fund managers may have contributed to the tech stock bubble. Professor Robin Greenwood discusses the research paper, "Inexperienced Investors and Bubbles," and what mutual fund investors should keep in mind. Key concepts include:

  • The research supports theories that inexperienced investors are prone to buy assets with inflated prices during times of bubbles.
  • Even professionals are susceptible to trend-chasing. Fund managers under the age of thirty-five were more likely than older managers to overly invest in tech stocks in the last bubble.

 

"Past performance is no guarantee of future results." —standard financial disclaimer

Neophyte investors—it is believed—play a role in creating asset price bubbles such as the tech collapse a few years ago. Just think back to the seventeenth century Tulip Bubble when, as journalist Charles MacKay observed in 1852, "even chimney-sweeps and old clotheswomen dabbled in tulips."

These days it's not just chimney-sweeps who are lured to investment heartbreak. New research suggests that even professional fund managers—if they are also young and inexperienced—can be fooled into joining a bubble. In the recent paper, "Inexperienced Investors and Bubbles," Harvard Business School's Robin Greenwood and Stanford's Stefan Nagel compared the returns of young and older mutual fund managers during and after the technology stock bubble starting at the end of last decade.

The results show that inexperienced fund managers as defined by age (under thirty-five) exhibited trend-chasing behavior that produced over-investment in tech stocks. "Our results fit well with adaptive expectations models of learning," the coauthors write. "According to this interpretation, the trend-chasing behavior of young managers reflects their attempts to learn and extrapolate from the little data they have experienced in their career."

Did the young fund managers also play a significant role in pumping up the bubble? The evidence is still out, but it is known that at the peak of the market a significant fraction of institutional money was controlled by young managers, thanks in part to rising prices for tech stocks, the researchers say.

We asked Greenwood to discuss the research and its implications for investors.

Sean Silverthorne: Let's start at the end: What did your research show was the role played by inexperienced mutual fund managers in creating the technology stock bubble?

Robin Greenwood: Our interest was in understanding the role of investor experience in the formation of bubbles. One well documented feature of the technology bubble was that younger investors were lured in. If you read historical accounts of the Tulip Bubble, as well as other famous examples, it turns out that this is pervasive.

Our intuition was that this might explain how these stocks became overvalued in the first place. That we cannot prove. However, we can show that inexperienced mutual fund managers were much more likely to deviate from their benchmarks and purchase technology stocks during the 1998-2000 period.

Q: Your research shows little deviation between younger and older mutual fund managers at the start of the bubble, but as time advanced the younger managers over-invested in technology stocks. Why are the less-experienced managers drawn to technology?

A: Our hypothesis is that younger managers, and inexperienced investors more generally, are more likely to extrapolate past price movements when forming their forecasts of future returns.

There are countless examples of bubbles throughout history in which inexperienced investors were lured in. Somewhat surprisingly, young managers were not that good at evaluating technology stocks. Although they experienced high returns when technology stocks did well, we show that if one controls for their exposure to technology, younger managers underperform. Underperformance gets worse after 2000, not surprisingly.

Q: Why aren't older managers as likely to chase a bubble?

A: For two reasons. First, they have had more market experience, and know that past returns do not imply future performance. Second, they may have lived through some years of particularly bad returns. This tends to make investors more cautious.

Interestingly, fund managers older than forty—just old enough to have lived through the 1987 crash—were particularly unlikely to bet on technology stocks relative to their younger counterparts.

Q: An interesting fact in your work is that even after the bubble burst, investors continued to pour money into funds managed by inexperienced managers despite their poor track records.

A: Yes, but inflows slow down considerably. This relates to the well-known fact that mutual fund flows are "sticky"—funds that perform well attract considerable inflows, but funds that underperform receive only modest outflows. Thus, it's not clear that inexperienced managers were punished for the decisions they made during the bubble.

Q: Your research focuses on inexperienced (as reflected in age) fund managers, yet you would think these folks are still experienced investors. They must have some track record to have a fund handed over to them to manage. So is it really a matter of time and experience that deepens your investment skill, or is there also something to being a fund manager (as opposed to being a lone or non-professional investor) that broadens the experiences you learn from?

A: We were surprised to find these results among mutual fund managers, who a priori one would not expect to be subject to these kinds of biases. After all, they are better trained than your typical investor. We expect these biases to be even more severe among the general public.

Q: What have we learned about how inexperienced fund investors affected financial bubbles before the 1990s? Can't we learn by past mistakes?

A: Our research shows that, unfortunately, investors do not take the time to look at history. Learning occurs by doing, or in our case, by investing and experiencing the returns that result from one's investment decisions. I remember several commentators criticizing legendary (and older!) value investor Warren Buffet for his reluctance to invest in technology stocks. It turns out he was right.

Q: How did your research advance previous knowledge on bubble formation, "herd" mentality, and other work in this area?

A: While there are scores of anecdotal accounts of inexperienced investors being lured into the market during times of bubble, our paper is the first systematic evidence. Having said that, there is some interesting experimental work, conducted during the 1980s, in which participants in a simulated financial market were asked to make investment decisions. The overwhelming conclusion from this work is that investors that had not yet experienced a downturn in returns are more likely to infer that prices would continue to go up.

We thought the experimental work was interesting, but wanted to know whether those results had anything to do with real-world financial markets. Our main contribution, I think, is that we show that the identity of the marginal investor can change over time. We usually think of mutual funds as relatively sophisticated investors, perhaps even exerting a stabilizing influence on price at times when individual investors are going crazy. Unfortunately, during bubble periods, the mutual funds that receive the most inflows are being managed by the most inexperienced people. Thus, at the peak, inexperienced investors end up controlling a significant portion of assets and thus have the power to sway prices.

Q: What are you working on next?

A: Our current work has focused on mutual funds, but we are interested in understanding the effects of inexperience more broadly. We are working on a project that looks at individual investors' trading decisions in their brokerage accounts.

About the author

Sean Silverthorne is the editor of HBS Working Knowledge.