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When bubbles burst

Many of you think US tech stocks and cryptocurrencies are in a bubble. Which poses the question: who would lose if or when such bubbles deflate? The answer might be surprising.

You might think it would be simply uninformed investors. Not necessarily. If you buy and sell at random you have a chance of buying near the bottom and selling near the top simply through dumb luck.

Instead, the biggest losers would be those who consider themselves informed but who are not. As Mark Twain allegedly said: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” What costs us money is not genuine ignorance but overconfidence, following the herd and buying into narratives. A little learning is indeed a dangerous thing. In a recent study of Japanese investors Kansai University’s Taizo Motonishi found that the well informed were more error prone in some ways than less sophisticated investors. “Financial literacy makes people daring and reckless in some financial aspects,” he says.

Some new research corroborates all this. William Quinn and John Turner at Queens University Belfast studied an early bubble – that of bicycle stocks which trebled in price in 1896 only to slump thereafter. (Yes, they were cyclical stocks). They found, perhaps unsurprisingly, that insiders – employees and directors of bicycle companies – got out near the top and so profited from this episode. The biggest losers, however, were not uninformed investors such as tradesmen and clergymen (a more affluent group back then than now). Instead, they say, they were “men with considerable wealth, plenty of free time, and a convenient nearby stock exchange, who were very active traders during the mania”.

More recent history fits this pattern. During the tech crash of the early 2000s it was some day traders who lost the most – those who, like the Victorian gentlemen, had the time and money to trade actively.

This warns us that 'democratising' finance can be dangerous in some respects. The Robinhood app which offers commission-free trading has enabled huge swings in so-called meme stocks such as AMC and Game Stop in which some amateur traders have lost heavily. Back in 1936 Maynard Keynes praised the London Stock Exchange for being “inaccessible and very expensive” precisely because it deterred those with too much time on their hands from active trading, thereby dampening down speculative booms and busts.

Yes, having the leisure time that retirement brings might give you the chance to research stocks more thoroughly. But while this gives you an edge over uninformed investors it doesn’t necessarily give you one over insiders or professionals who have even more resources than you. Instead, it can give you an illusion of knowledge and overconfidence that emboldens you to trade too much and take too big positions.

Some things are more important to investors than knowledge. We need the discipline not to trade excessively, the humility to avoid overconfidence, and the wisdom to avoid wishful thinking and being swept along by a mania. Such traits are rare.

While such irrationality is expensive for those making these errors, it is not always costly for society as a whole, however. In his book Pop!, Daniel Gross showed that bubbles can actually be a good thing because over-inflated share prices cut the cost of capital and so encourage investment in long-lived assets which benefit us all years after the bubble has burst. The railway mania of the 1840s left a legacy of a dense rail network and the tech bubble of the 1990s fuelled investment in broadband and 3G, as well as giving thousands of software writers valuable experience – all of which led to the development of smartphones, tablet computers and the apps we use on them.

The legacy of the bicycle boom was even greater. Affordable bikes gave people, and especially women, the real freedom to move outside their own confined area and to couple up with partners from further afield. This increased genetic diversity, with health benefits we are still enjoying today. Those idle rich gentlemen amateurs who fuelled the bicycle bubble were unwittingly great social benefactors. As Friedrich Hayek said (albeit for a different reason) “the poorest today owe their relative material well-being to the results of past inequality”.

Whether the same is true today is, however, doubtful. It’s not at all obvious that cryptocurrencies will have any longlasting wider benefits (although, of course, our ability to foresee future technical changes is very limited), and the gains from high prices of big US tech firms might be confined to decent TV streaming services, which is small beer compared with previous bubbles.

Our problem, then, isn’t so much that there are bubbles, but that the bubbles are in the wrong things.