Reading the money pages in the weekend newspapers can be quite intoxicating. Most weekends there are articles about the next big idea to invest in. It might be artificial intelligence, “meatless meat” or driverless cars, for example.
The ideas always seem so plausible. Journalists and fund management companies are highly skilled at weaving compelling narratives to reinforce the case for taking the plunge. But investing in the next big idea isn’t just a bad idea; it can also be very risky.
There have always been fashionable things to invest in. In the 1840s, for example, investors got very excited about railway companies. In the 1890s, believe it or not, bicycles were the next big idea. In the 1960s, when electronics was all the rage, a whole slew of companies sprung up with some garbled version of the word “electronics” in their name, which usually inflated their price, even if the company had nothing to do with electronics! In more recent memory, the late 1990s saw a rapid rise in the stock prices of internet-based companies, or “dotcoms”, driven by the excitement around the potential of the internet.
In all of those cases, the logic for investing appeared to be sound. Railways were a game-changing technology for the whole economy; bicycles enabled ordinary people to travel around more easily; electronics also transformed our lives, making complex tasks at work and home much simpler; and, as we all know, the internet has arguably had the biggest impact of any of those things.
In all four cases, however, most (yes, most) of the investors who tried to profit from these ideas ended up having their fingers badly burned.
The Big Market Delusion
Why, then, do new technologies that hugely benefit consumers and society often harm investors who try to capitalise on them?
Well, an important phenomenon for investors to grasp is the so-called “Big Market Delusion”. The concept was developed by Bradford Cornell and Aswath Damodaran in a 2019 paper called The Big Market Delusion: Valuation and Investment Implications.
When a new technology emerges that appears to offer great potential, Cornell and Damodaran explained, investors often get over-excited. They think about how big the market could be and start believing that every company involved with this new technology will be a huge success. This leads to investors paying too much for shares in these businesses.
This situation creates a “bubble”, in which every company that could sell to this new market is valued as if it’s going to be a big hit. The problem is, if every company is seen as a winner, then the total value of all these companies is more than what the technology is actually worth. This means that some, or all, of these companies’ shares are probably priced too high.
These overpriced stocks can stay that way for a while. Since these are new technology companies, not many people are trading their shares. They’re harder to buy and sell, and their prices can change substantially. It’s also riskier and more expensive to bet against, or “short”, these stocks. Another problem is that these companies are sometimes bought by other companies for a high price, making people think that similar companies are also worth more than they actually are.
Eventually, though, reality catches up. When it becomes clear how much money these companies can actually make, their share prices usually fall. This happens as more information becomes available about their real sales and earnings. Over time, the share prices of most of these companies will decrease to more reasonable levels, and it can happen very quickly.
So, for example, railway shares went up and up in price until around 1846, when the bubble burst, and most railway companies went out of business. The same thing happened with bicycles, electronics companies and dotcoms.
Yes, there are always a few big winners. If, for example, you were clever of lucky enough to buy shares in Amazon when it went public in 1997, and still hold them today, you can be very pleased with yourself. But, for every Amazon, there were thousands of dotcoms that went to the wall. The NASDAQ index in the United States, which is heavily weighted towards technology and internet-related companies, lost about 78% of its value between March 2000 and October 2002.
Four major warning signs
How, then, do you avoid getting caught up in a dotcom-style bubble? When you’re tempted to invest in the next big idea, what are the warning signals to look out for? In their paper on the The Big Market Delusion, Cornell and Damodaran suggested four main ones:
The market is huge: the larger the potential market, the more likely firms are to be overvalued
Investors are blind to competition: business is always highly competitive, so beware when investors underestimate the threat from rival firms
All the focus is on growth: yes, growth is important, but, ultimately, profitability matters more, so too big a focus on growth is another red light
There’s a disconnect from fundamentals: when share prices no longer reflect fundamental numbers like earnings, revenue and book value, investors should be very cautious
The danger of herding behaviour
Most investors understand, on a rational level, the danger of being sucked into investing in the next big idea without carefully considering it. But human beings are very social animals — we pay close attention to what those around us are doing, and we don’t like to miss out on opportunities that other people are benefiting from. So investors often resort to herding behaviour and pile into a particular investment just because everyone else is.
In his book Irrational Exuberance, the Nobel Prize-winning economist Robert Shiller argued that “anyone taken as an individual is tolerably sensible and reasonable,” but that, “as a member of a crowd, he at once becomes a blockhead.”
Herding has a considerable impact on market prices, with so-called positive feedback loops leading to self-fulfilling prophecies, as buying attracts more buying and pushes prices up.
Even the most intelligent people can get caught out. The mathematician, physicist and astronomer Sir Isaac Newton, for example, was one of the brightest minds of his era, and yet even he lost money in the South Sea Bubble of 1720. “I can calculate the motions of heavenly bodies,” he famously wrote of the experience, “but not the madness of people.”
Lessons for investors on the next big idea
So, what are the lessons for investors to learn about investing in the next bid idea? Here are three key ones.
First of all, remember that investment fashions come and go. If you read about a big idea that seems to present an opportunity that’s too good to miss, think about it critically, preferably with the help of a financial adviser.
Remember, the question to ask is not whether a new technology will be hugely successful; but rather, Can I as an investor benefit from it? How do I know which companies will thrive if this particular technology takes off? How do I know that the company, or companies, that I invest in won’t be among the majority of businesses in this space that will probably fail?
Secondly, guard against overconfidence. In the short-to-medium term, stock markets are far less predictable than most people think they are. The vast majority of financial professionals fail to beat the market in the long run, so it’s unrealistic for amateur investors to assume that they will find it any easier. And yet many investors still think they have what it takes to outperform. In his book, Thinking, Fast and Slow, another Noble laureate, Daniel Kahneman, declared overconfidence “the most significant of the cognitive biases”.
So ask yourself: Are the so-called experts who are recommending investing in a particular technology guilty of overconfidence? Do they really have all the information they need to make this recommendation? Is there something they haven’t considered? Or might things develop in a way they haven’t anticipated? Also, are you being overconfident yourself? Do you genuinely have information or unique insight that other investors don’t?
Finally, if you’re concerned about overconfidence, and the danger of becoming an investing fashion victim, there’s a simple and rational option open to you. That’s to remove human decision-making from the investment process as much as you can, and to diversify broadly and invest in the whole market, using passive, or broadly passive, funds that track an entire index.
Taking this approach, which we at rockwealth call evidence-based investing, means you will still benefit from new technologies. However, you won’t be too heavily exposed if, like so many technologies before them, they turn into another bubble.