Stanford Business

MAY 2007


You Had to Be There to Avoid the Next Crash


Illustration by Stuart Bradford

Younger managers of funds invested aggressively in technology stocks as the bubble developed.

by Alice LaPlante

Investors who lived through the dot-com bubble are unlikely to forget it. But although the still-raw details of that era have been documented in countless publications—and are likely to be ensconced in MBA textbooks for decades to come—those who didn’t experience it will probably not learn from history.

“After a crash, people are quite aware of the potential dangers and adjust their investing behavior accordingly. But after 20 years or so, that memory is erased, and you again have the conditions that make another bubble possible,” says Stefan Nagel, an assistant professor of finance who teaches the core finance class to MBAs, as well as a course in empirical finance in the PhD Program. With coauthor Robin Greenwood of Harvard Business School, he researched how investors form expectations for the future, as well as market conditions that lead to bubbles. “In this study, we were trying to connect those two things,” he says.

Past theoretical studies and laboratory experiments have examined these topics, but “there is a big gap between these experiments in artificial laboratory settings and the empirical research we performed,” Nagel says. He and Greenwood examined the portfolio decisions of experienced and inexperienced mutual fund managers during the technology bubble of the late 1990s. They used data from Morningstar, a provider of mutual funds research and ratings that maintains a database of funds and profiles of their managers.

Categorizing fund managers by age, the researchers found that younger managers bet on technology stocks at rates that actually trailed those of older managers at the start of the bubble in 1997. But leading up to the bubble’s peak in March 2000, younger managers dramatically increased their holdings of such stocks.


Stefan Nagel

“The funds by younger managers took aggressive positions in technology stocks—much more than those by older managers,” Nagel says, particularly after quarters when technology stocks had done well. “Young managers chased the trend, but older managers did not.”

As the bubble developed further, new money flowed into funds run by the younger managers. This seemed to be driven by the fact that investors tend to “chase” funds that have been performing well. “At the beginning of the bubble, younger managers tended to perform better than older ones, thus attracting more investors to their funds and perpetuating the cycle,” Nagel says. The result was that although younger managers started out in 1997 with relatively small funds, the amount of money they controlled had quadrupled by March 2000 when the bubble finally burst.

After the bubble ended, younger managers experienced “outflows”—investors taking money out of their funds—but not more so than comparable funds run by older managers. “Thus for mutual companies, the failed dot-com investments of younger managers turned out to be not that costly,” he says. “For those investors who piled into young managers’ funds before the peak of the bubble, the picture looks different, of course.”

These results point to a difference in beliefs of younger and older fund managers. “It seems that older managers were more skeptical about how well these technology stocks would do in the future,” Nagel says. That might surprise economists, who in theory believe there should be no difference whether a fund manager has firsthand experience or not. Knowledge is what matters, regardless of how it has been acquired. “Even if you’re a younger manager, you should still have learned about past bubbles and what happened in the stock market over the past 100 years. In fact, MBA programs teach this,” Nagel says. “But it turns out that on-the-job experience is what counts.”

In a related project, he and Ulrike Malmendier, an assistant professor at the University of California, Berkeley, see evidence that personal experience dramatically impacts individuals’ investment decisions. “If someone lived through the Great Depression, or was young in the 1970s or 1980s when stock market performance was very poor, and experienced lousy returns, he or she is much less likely to put money in stocks,” Nagel says. “Almost inevitably, they choose other assets to invest in.”

The implications of these studies are a bit ominous. “Go out 20 or 30 years from now, and it’s possible we’ll see another bubble,” Nagel says. Is there a moral here? Always invest in funds with older managers? Not necessarily. “After all, if you had ridden the tech boom for the short run only, you would have done very well,” he says. Over the long term, of course, it would have paid off to have gone with an experienced manager. “So it’s very difficult to generalize.”

Read the paper.

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