RENEE MONTAGNE, host:
Our Planet Money team, as part of their most recent adventure in investment journalism, purchased a tiny gold coin. They bought it last fall and it cost them $419. Six months later, as planned, they have sold the coin. In this final story, David Kestenbaum and Jacob Goldstein tell us how they did. And they also try to figure out if gold or anything is in a bubble.
JACOB GOLDSTEIN: To understand bubbles, some economists are trying to recreate them. But in a way that won't destroy the global economy.
DAVID KESTENBAUM: They do it in a safe environment - a university - using students as traders and real money.
Professor ARLIE WILLIAMS (Indianan University): I've got a big wad of about $400 in cash. And I hope to give it to these traders in about oh, probably about three and a half hours from now.
GOLDSTEIN: This is Arlie Williams, a professor at Indiana University. Back in the 1980s he helped run one of the first of the first experiments trying to create a bubble in the lab.
Prof. WILLIAMS: Our thinking going in was we might be able to do it. I thought we would see bubbles, but very infrequently.
KESTENBAUM: In the lab, they set up the world's simplest stock market. There is one stock to trade, and it's designed to have a clear value. At the end of every round it pays you a little money, on average, say $1. So if there are ten trading rounds left in the game, it should be worth around $10. And at the end of the game, you know it's worth zero.
GOLDSTEIN: And they make this very simple. The student traders look at computer screens that say this stock should be worth $10 or should be worth $5 or whatever.
KESTENBAUM: And yet? Bubbles. The stock will shoot up way over the rational value. Sometimes beyond what it could possibly even be worth. And then it crashes. And this doesn't just happen occasionally.
Prof. WILLIAMS: Probably 90 percent of the time, you will see a speculative bubble and crash.
GOLDSTEIN: In class, he'll even point out to the students, in the middle of trading, in the middle of the bubble, the insanity of what they are doing.
Prof. WILLIAMS: The first time I ran this with a big class, it was a double-decker auditorium and, you know, had this digital projection, and I'd say OK, now, right now the fundamental value of a share is $8 and look at this graph. You know, you're trading shares right now at $14. What do you think about this?
(Soundbite of laughter)
Prof. WILLIAMS: And thought: This is going to just destroy this market. I mean, it's going to crash back down to fundamental value instantly. And I went back to my office and fired up my computer and went in to see what was going on. And the price for next two trading rounds, prices went up even farther. And so, showing people basically that the market was in a price bubble just fueled the price bubble even more.
GOLDSTEIN: So basically, with that class, you said: Hey, look. There's this huge bubble. And rationally, what should happen then is the bubble should burst. That should be the end of it, but instead, everybody is like: There's a bubble, I got to get in on it - buy, buy, buy.
Prof. WILLIAMS: That's precisely what happens.
(Soundbite of laughter)
KESTENBAUM: One explanation for bubbles is what's called the Greater Fool Theory. People figure they can sell the stock to some greater fool, who will pay even more for it.
GOLDSTEIN: Another thing that can cause bubbles: People don't always have great information about what's going on. So they just follow the crowd.
KESTENBAUM: And once bubbles start, it can be hard to put the breaks on. If you think home prices are going up, you can buy a house, or two houses. But it's hard to bet the other way, that home prices are going to fall.
GOLDSTEIN: The people in the experiment, they were buying the stocks for sometimes for more than it could ever pay out. And this gives us a definition of a bubble: It's when the price of something rises way above what you might call its fundamental value.
KESTENBAUM: So let's apply that definition to gold: Is gold in a bubble? Here's Tim Harford. He's an economist and a columnist at the Financial Times.
Mr. TIM HARFORD (Economist and Columnist, Financial Times): Gold is a tricky one, and here's why. Remember we said bubbles should be defined in terms of fundamental values? The price of corporate stock should be looking at future profits, and you need to make your best judgment on what that would be.
But price of gold, it's just not clear what the fundamental value of gold is. I mean, it's worth something because people have always thought it's worth something. And that's really weird, because what that really tells you is, well, gold's in a 4,000-year-old bubble. And if it's lasted 4,000 years, maybe it'll last another 4,000 years. Who am I to say?
GOLDSTEIN: We promised we'd sell our gold coin six months after we bought it. So we did.
HANK MENDELSOHN (Gold Standard): How are you guys, by the way?
This is Hank Mendelsohn, the guy who sold us the coin.
KESTENBAUM: The price of did gold go up, from around $1,300 an ounce to over $1,400 an ounce.
GOLDSTEIN: But we had to pay Hank a commission. He has to keep his store open. And on top of that, because the coin was so small, we had to pay sales tax when we bought it.
Mr. MENDOLSON: One ounce, you made money. The quarter ounce, you didn't make money, because it was too small a denomination.
GOLDSTEIN: You're going to tell me we got killed by sales tax?
Mr. MENDOLSON: Absolutely.
KESTENBAUM: Count it out.
GOLDSTEIN: One, two, three.
All told, we lost $43.
KESTENBAUM: the Planet Money investment fund found a way to get in on the way up, sell before the peak, and still lose money.
I'm David Kestenbaum.
GOLDSTEIN: And I'm Jacob Goldstein, NPR News.
(Soundbite of music)
MONTAGNE: You're listening to MORNING EDITION, from NPR News.
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