Inexperience Fund Managers and Bubbles

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. The 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."

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.


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.

The author's 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.



The 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: 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.



Source: http://hbswk.hbs.edu/item/5618.html