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Stanford GSB News

 

Investors Fear Missing a Sure Thing
More Than They Fear Risk

October 2007

STANFORD GRADUATE SCHOOL OF BUSINESS—Why do people herd around risky investments, causing “bubbles” that inevitably burst and leave most investors losers in the game? Couldn’t the players in the dot-com bust, for example, have seen disaster looming on the horizon? Why did more investors not get out earlier, and why did they continue to pump money into already overinflated stocks? Similar questions surround the recent bust in the subprime mortgage market.

Two Stanford researchers decided to investigate the possibility that what investors fear the most is not the risk of a loss per se, but the risk that they may do poorly relative to their peers. Their results indicate that even though investors know investments in areas such as new technology often are particularly risky, they tend to cluster around pie-in-the-sky opportunities to avoid being the only one in the community to miss out on the “next big thing.”

In three related theoretical studies, Peter DeMarzo and Ilan Kremer, along with Ron Kaniel at Duke University, have discerned that individual investors care deeply about how their level of wealth compares to that of others in their peer group and community. “Investors fear most being poor when everyone around them is rich,” says DeMarzo, the Mizuho Financial Group Professor of Finance at the Business School.

A primary reason for people’s concern, they explain, is that the cost of living in any community may depend on the wealth of its residents. The more money people have, the more expensive houses, real estate, daycare, and other necessities and amenities will be. “It’s worse to have a lower income in an area where everyone is wealthy than it is in an area where everyone has a similar income as you,” says Kremer, GSB associate professor of finance.

After showing that these relative wealth concerns arise naturally when investors compete over scarce resources, the three were able to provide rational explanations for why both individual investors and companies might overinvest in risky investments and technologies. Specifically, people are most likely to follow others in their community or professional cohorts into technologies with a small chance of a high payoff. “Herding around certain investments allows you to combat the fear that everyone else might be betting on the winner while you’re not,” DeMarzo says.

He and his colleagues have thus found that the traditional economic assumption that people are driven by the straightforward desire to maximize their wealth is simplistic. Once actual consumption decisions are considered, peer pressure also comes into play.

“We might classify behavior based on relative wealth as ‘irrational,’ but in choosing similar, risky portfolios, investors are actually doing what makes sense to them,” Kremer says.

The researchers say that investors would tend to herd particularly around high-tech investments that have the potential to revolutionize the entire market and promise a big upside––technologies like fiber optics, internet-related infrastructure, and so forth. “These are typically high-risk stocks that, in seven out of eight cases, are likely to go bust. But people are willing to invest in them in the hopes that they’ll hit that one-in-eight jackpot,” DeMarzo says.

This herding behavior explains how stock bubbles emerge. When people begin crowding to certain investments, the price of the assets they hold becomes overinflated. The standard model says that if stocks are overpriced, smart investors will sell or avoid such investments. But DeMarzo and Kremer find that even if people know a stock is overpriced, their fear of doing something different from their peers and potentially losing out makes them move in ever greater numbers to the swelling investment.

Firms’ decisions to invest follow suit, the researchers have discovered. In the late 1990s, telecommunications companies, for example, overinvested in droves in fiber optics. Because they ended up laying far more lines around the country than were needed, by 2003 the value of fiber-optic networks fell by more than 90 percent from its all-time high. Telecommunications companies accounted for 60 percent (by net worth) of U.S. corporate bankruptcies.

For individuals, herding also can provide a kind of buffer when the bubble bursts. “If everyone loses his or her money together, it’s perceived as not as bad as if you lose alone,” says DeMarzo. Thus the “keeping up with the Joneses” school of investing has benefits on the upside as well as the downside.

—Marguerite Rigoglioso