The Effects Of A Financial Bubble On The Market : Planet Money Investing during a bubble can leave you bust. But how to tell the difference between a bubble before it bursts and an investing rocket ship taking off? We'll run through a historical example and look inside our own thinking to find the mental biases that can contribute or exacerbate bad bubble thinking. | Subscribe to our weekly newsletter here.

Planet Money Summer School 5: Bubbles, Bikes & Biases

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SYLVIE DOUGLIS, BYLINE: This is PLANET MONEY from NPR.

(SOUNDBITE OF BRICE MONTESSUIT AND CHARLES CASTE-BALLEREAU'S "LOST SITUATION")

CARDIFF GARCIA, HOST:

Hey, everybody. This is Season 2 of PLANET MONEY Summer School, the investing education that goes in one ear and then stays between both ears. Today is Class 5 - bubbles, bikes and biases. A financial bubble can form in pretty much anything that can be bought and sold. Could be a single stock or the whole stock market, bonds, houses, bikes, flowers, Pokemon cards, whatever. All you need is for the price of that thing to go up and up and up beyond what seems justified. And all that happens before the bubble bursts and the price collapses.

But financial bubbles are also quite mysterious. Why do they form in the first place? And how do you know that something is even in a bubble? Because sometimes a thing does just get popular and then stays popular - like, you know, podcasts, we hope. And what traits do most bubbles have in common?

Well, joining us once again is PLANET MONEY Summer School professor Vicki Bogan. Vicki also happens to be a non-podcasting professor at the SC Johnson College of Business at Cornell University. Vicki, I think we should make this a short class - just one question and one answer. So here it is; what causes financial bubbles?

VICKI BOGAN: So you've asked the bazillion dollar question.

(LAUGHTER)

GARCIA: So if we find a way to answer it, then we are owed a bazillion dollars, right?

BOGAN: (Laughter) Exactly. There's no general consensus. You ask 10 people in the finance world, you may get 10 different answers.

GARCIA: All right. Well, I guess we'll stick around for a full class then. So Vicki, the price of an asset might shoot up quickly and massively. And for any one specific bubble, we might even be able to guess the reason. But we don't have a good answer as to why bubbles happen in general is what you're saying.

BOGAN: Yes. The other issue that I would point out is that in almost every bubble, there seems to be some form of innovation that forces people to rapidly debate the creation of new economic value. There's this uncertainty regarding the innovation. We saw that with the tech stock bubble, where we had the internet stocks go up precipitously. And some of these companies really had no track record, no cash flows, no revenues, to support the price that was being traded on the markets.

GARCIA: Yeah. What I remember about that tech stock bubble from the late 1990s - and which, by the way, collapsed spectacularly in the early 2000s - is that there were plenty of warnings that it was a bubble even as it was happening, warnings that these stock prices could not possibly be justified. But people who got swept away by it and invested their money in all these terrible companies would say, oh, well, you just don't understand these new companies. You just don't get it. These companies eventually will make a lot of money. But of course, they did not. And it collapsed, and it was very dramatic.

BOGAN: Yeah, it was dramatic. And the other interesting thing about that particular bubble was that some of the companies did have sound business models and ended up doing quite well, and some of the companies did not have sound business models, but they had that internet story. And people tended, at the time, to paint all companies related to the internet with the same brush and really didn't look at the actual fundamentals of the specific firms.

(SOUNDBITE OF MUSIC)

GARCIA: OK. Well, maybe the best way to understand bubbles is with the story of the rise and fall of one single bubble. So coming up, we are going to listen to a classic episode from The Indicator, which is PLANET MONEY's daily show. And for those of you who are steeped in financial history, the answer is no, this episode is not about tulips.

(SOUNDBITE OF MUSIC)

GARCIA: This episode of The Indicator that we are about to hear first aired in December 2019. It was hosted by Paddy Hirsch and Stacey Vanek Smith. And it took place during a week in which all of The Indicator's episodes were about the bubbles of the past.

(SOUNDBITE OF ARCHIVED NPR BROADCAST)

PADDY HIRSCH: And these bubbles in the past have also been called manias, implying a kind of madness on behalf of consumers.

STACEY VANEK SMITH: And in the 1890s, there was an actual bicycle mania in Britain - the great British bicycle bubble.

HIRSCH: As opposed to "The Great British...

VANEK SMITH: ...British Bake Off."

HIRSCH: ...Baking Show (ph)," which, of course, is also a mania.

VANEK SMITH: That's true.

HIRSCH: And prior to 1890, bicycles were expensive, impractical and really uncomfortable. I mean, think about that penny farthing - right? - with that big front wheel and that tiny back wheel.

VANEK SMITH: It's terrifying.

HIRSCH: Terrifying.

VANEK SMITH: It seems so treacherous.

HIRSCH: Right. And you fall off that thing, and that's it.

VANEK SMITH: Goodbye.

HIRSCH: Will Quinn is a professor of finance at Queen's University in Belfast and something of a specialist on the great British bicycle bubble. He says right around 1890, the British bicycle business went through a period of rapid innovation.

WILL QUINN: So they invented the diamond frame, and they invented and the chain, which meant you don't need this big front wheel anymore. And they invented the pneumatic tire, which was great for the poor-quality roads that existed at the time.

VANEK SMITH: The new bicycles looked pretty similar to the bicycles that we ride today. They were safer. They were more comfortable. And they gave riders a relatively cheap and quick way to get out of the smog-wreathed cities of industrial Britain and into the glorious countryside. They were a huge and immediate hit. Newspapers ran these lavish stories about the cycling lifestyle, and there was this huge spike in ridership, especially among the ladies.

HIRSCH: And bicycles weren't exactly cheap - about 10 pounds on average, when a decent working-class wage was about 300 pounds a year.

VANEK SMITH: Whoa. That's like a Lexus.

HIRSCH: Yeah (laughter).

VANEK SMITH: Right?

HIRSCH: It kind of is like a Lexus. But there were a lot of rental companies out there that rented bikes for as much as a pound a week. And a cycling caught on, with people joining cycle clubs all over the country, people began buying their own bikes.

QUINN: It really started in the spring of 1896. So at this point, it's become clear that something's going on with bicycles. They're much more popular. There's very high demand that the existing companies can't really meet.

HIRSCH: There were about 15 or 20 public companies making bicycles at this point. But with so much demand, there's clearly an opportunity for an entrepreneur with a little pizzazz and flair - someone like Ernest Terah Hooley. This guy's a property dealer and a bit of a scoundrel, frankly, who somehow manages to convince a bank to give him a massive loan.

VANEK SMITH: Hooley then pays this heart-stopping amount of money for a company called Pneumatic Tyre - 3 million pounds. That's nearly 10 times the company's original valuation. It's like an early unicorn - ye olde unicorn. He renames the company the Dunlop Pneumatic Tyre Company. And then he turns around and flips that company. He sells it for 5 million pounds.

HIRSCH: And Dunlop wasn't a bicycle-maker. It made tires. But still, entrepreneurs all over Britain witnessed the apparently massive success of this trade. And now everybody wants to be in the bicycle business.

VANEK SMITH: Within a year, the number of public companies associated with bicycle manufacturing goes from a couple dozen to more than 100. There's the Birmingham Small Arms, Humber & Co., Rudge of Coventry, the Raleigh Cycle Company and dozens of others. And all of them are competing in the stock market to raise capital to make bikes for the cycle-crazed people of Britain. And you can just see this bubble swelling.

HIRSCH: Except that this bubble isn't actually about the bicycles so much. It's about the shares of bicycle companies. Because the price of a bicycle stays about the same throughout 1896, but the price of bicycle company stock goes up like a rocket.

QUINN: You had a very rapid run-up in prices, so prices rose by about 200% in two months in 1896.

HIRSCH: Wow, 200%.

QUINN: Yep, 200%. And this early stage of the mania is very easily explained. So you have high dividends at these companies. You have these spectacular mergers taking place, and prices rise accordingly. The really hard part to explain is why, a year later, prices are even higher, even though you now have four or five times as many companies on the market. And they're not all - clearly not all going to survive.

HIRSCH: So part of the puzzle was that even though there were many more companies making bikes, increasing the supply to more than match demand, none of them cut their prices much.

QUINN: So the price of bicycles stayed much the same. There was some sort of unofficial collusion between the British companies, where they agreed to just compete on quality.

VANEK SMITH: There was only so long that that could last. I mean, there was this intense competition, and nobody was cutting their prices. And there was this massive increase in the supply of bicycles that basically threatened to overwhelm demand. And then, as happens, the Americans arrived.

HIRSCH: (Laughter).

VANEK SMITH: When American mass-made bikes entered the market in 1897, it was basically like the entire British bicycle business had ridden over a nail. The American bikes were kind of scorned by purists who preferred the handcrafted machines that the Brits made. But the American bikes were cheap. They were just $25, which translated to about 5 pounds, which was half the average cost of a British bike. And they worked just fine - apparently not the same problems with the electrical systems. Oh.

HIRSCH: Oh.

(LAUGHTER)

HIRSCH: Anyway, the popularity and ubiquity of these American bicycles forced British firms to slash their prices at last. So it was clear to any objective observer that a lot of these companies - these British bike-makers - couldn't stay in business for long. And yet, Will Quinn says, share prices remained stubbornly high. And one big reason for this might sound familiar.

QUINN: A lot of the press at this time were very excited about bicycles, particularly the specialist press. So there was this body of cycling enthusiasts who would not have a bad word said about bicycles, who were just insistent that bicycles were the future, that anyone who thought that bicycle shares were overvalued just did not understand the spectacular potential of this new technology.

VANEK SMITH: It's like Silicon Valley.

HIRSCH: Bitcoin.

VANEK SMITH: It was Silicon Valley. Oh, my gosh, Bitcoin.

HIRSCH: (Laughter). Financial bubbles tend to expand slowly and then pop with a loud bang, like the housing bubble that popped in 2008 and caused a financial crisis. But the great British bicycle bubble did the reverse. It expanded very quickly in just two months in 1896. But it took several years to deflate completely, so kind of more of a slow puncture than a bursting bubble, like the nail stayed in the tire.

VANEK SMITH: In fact, it was nearly five years before the market really began to shake out. Of a total of 140 public bicycle manufacturing companies, 40 went bankrupt by 1901. And over the next 10 years, another 60 went out of business or just pivoted to other industries as bicycle prices fell. And the share of bicycle companies returned to a kind of equilibrium.

HIRSCH: And by the way, that tremendous trade that started it all - when Ernest Terah Hooley bought Dunlop for 3 million pounds and sold it for five - in the end, he admitted that he'd spent so much money on advertising and marketing to juice the share price that he only cleared about 100,000 pounds.

VANEK SMITH: That still sounds - isn't that still a lot?

HIRSCH: Not really.

VANEK SMITH: No.

HIRSCH: Not if you're thinking about that kind of investment. I mean, that's only - that's like a...

VANEK SMITH: It's not Amazon money.

HIRSCH: It's certainly not Amazon money. So I'm sorry to burst your bubble there, Stacey.

VANEK SMITH: (Laughter).

GARCIA: And Cardiff again here. We are going to take a quick break now. And when we come back, the behavioral biases that make bubbles worse or why bubbles are just human nature.

(SOUNDBITE OF MUSIC)

GARCIA: OK. PLANET MONEY summer school class is in session once again. And I am now joined by Vicki Bogan of Cornell. Vicki, there's an idea that I know you've written about, and it's really useful for understanding bubbles. It's known as the greater fool theory. What is it?

BOGAN: OK, so actually I talk a lot about this in my course. The greater fools theory is the idea that during a market bubble you can make money by buying overvalued assets and selling them for a profit later. So suppose you buy the internet stock, for example, and you know you're paying more than it's worth. But you also believe that you can sell it to somebody else that believes in the bubble for a higher price and make money before the, you know, bubble bursts. And so when you think about the name, the greater fool's theory, it's referring to the fact that you're buying of that asset that you actually know is overvalued - it's not worth what you're paying for it, but you're banking on the fact that you'll be able to find somebody else that's a bigger, quote, "fool," unquote, to buy it for a higher price that will still allow you to make money.

GARCIA: Yeah. And what's intriguing about this idea is that I might be thinking, well, I'll buy this overpriced stock because I think I'll be able to sell it to somebody for an even higher price, a greater fool. But that person might also be buying it from me for the exact same reason and on and on and on. And, of course, when you have all these people buying stocks at higher and higher prices, that just continues to fuel this stock price way above what it actually should be worth if you're just looking at how good the company is.

BOGAN: The problem with that strategy is that you have to buy it and sell it to a greater fool before the bubble actually bursts. And you don't want to be the one left holding the stock when the music stops.

GARCIA: You don't want to be the greatest fool, right?

BOGAN: (Laughter) Exactly. That's a great way to put it. Exactly.

GARCIA: And the greater fool theory is also consistent with a lesson from an earlier summer school class when we emphasized that it's a bad idea to try to time the swings in the market. And I remember that back in the housing bubble from the 2000s, there were some people who were taking out a mortgage to buy a house expecting to just resell that same house within a matter of months, basically just to flip it for a profit, because they expected house prices to just keep going up forever. But, of course, that didn't happen. And if you were stuck owning that house when prices started going down, you would have lost a ton of money.

BOGAN: There was an interesting feeling with a lot of people. It's a behavioral bias that we call excessive optimism. It's when an individual underweights the probability that something bad happens or overweights the probability that something good will happen. And with the real estate market in particular, during that time, there was a lot of excessive optimism that people thought real estate prices would never go down.

GARCIA: Yeah. And that also seems to highlight the role of stories or societal narratives in bubbles because, of course, if this story becomes pervasive, the idea that real estate prices don't go down because historically that actually has been quite rare, then that story will start spreading all over the place. And it makes it feel safer for other people to also start to invest in real estate and to borrow more money to buy more houses or to buy bigger houses than they can sort of justify based on their incomes.

BOGAN: Yeah. I agree with that. And I think another aspect of what you're describing is something that we call, in behavioral finance, herd behavior. So herd behavior means that we are kind of biologically wired to mimic the actions of the larger group. And so biologically, this behavior can be beneficial because it allows us to quickly absorb and react based on the intelligence of those around us. But it can also lead to reinforcing bubbles and these types of market anomalies. So you see that everybody's buying this stock or everybody's, you know, purchasing a home. And so, as you said, you feel more comfortable doing that because you see everyone around you doing that. And again, that can contribute to the run-up of asset prices as well.

GARCIA: So in a bubble, we're like, I don't know, a herd of elephants, right? I mean, that's a terrible mixed metaphor. But basically, we all go stomping in the same direction. It's loud, and it's noisy. And even though we all like to believe that we think independently and we think for ourselves, actually, it's really hard not to follow the herd, especially if it seems like everyone else is making a ton of money while prices keep going up.

BOGAN: And actually, that points to another important bias that affects behavior. It's the FOMO, the fear of missing out. So you see everybody buying cryptocurrency, and everybody seems like they're making a lot of money. And so you feel like, well, maybe I'm missing out on high returns by not doing this, too. Because I see everybody else doing it, and so I have this fear of missing out. And those types of biases can also influence investor behavior in a way that may not be optimal.

GARCIA: Yeah. Is FOMO an official bias now? Can we count it as a behavioral bias? I love that.

(LAUGHTER)

BOGAN: I do.

GARCIA: Yeah.

(LAUGHTER)

GARCIA: I wonder if it went by some other phrase before, like some sophisticated sounding phrase from psychology. But the kids basically came up with a better description of it, which is FOMO, fear of missing out.

BOGAN: Well, so I'm an economist, not a psychologist. But I'll look into that.

GARCIA: (Laughter) Yeah, fair enough. Well, we are going to take a quick break now. And when we come back, it's never been easier for pretty much anyone to participate in financial markets. And that sounds great. But it might also make you more vulnerable than you realize to investing in a bubble.

(SOUNDBITE OF MUSIC)

GARCIA: Vicki, I want to talk about where to look for bubbles in a modern context. So trading apps, like the ones from Robin Hood and E*Trade and many, many others, have made it incredibly cheap and even sometimes free and also really simple to just open an online account and start trading, start buying and selling things. And in response, a lot of individual investors - and I don't mean people here with a lot of money, I mean regular folks - have jumped into the stock market and into other markets because of this technology. Are you worried that making it so easy will also lead people to make bad investments, and in particular, to invest in something that everybody else seems to be investing in, which is classic bubble behavior?

BOGAN: So let me start by saying, I think it's a good thing for households to participate in financial markets. I also think that reducing barriers to participation in financial markets is also good as well for households, for retail investors. Some of the cautions I would have with regard to some of these online brokers is that it's billed as if there are no transaction costs or transaction costs are free. And in the sense that there's no sort of per transaction or per trade direct fee, that's correct. But there's still transaction costs, and the transaction costs are in the form of a fancy term we call bid-ask spread. But it's not actually free. There are still transaction costs.

GARCIA: Yeah. And they're not visible (laughter), those costs.

BOGAN: And they're not visible.

GARCIA: They're not visible to everybody. Yeah.

BOGAN: You don't - there's no transparency. You don't know what they actually are. And so that is something to understand and be, you know, mindful of. The other thing - you know, we've been talking quite a bit about different behavioral influences and behavioral biases that can contribute to bubbles. One of the interesting things about some of these online brokers is they actually exploit some of these behavioral science techniques and information to try to get retail investors to trade more through their platform. The reason they do that is because through their business model, they make more money the more trades their users make.

GARCIA: Yeah. And how exactly do they exploit these behavioral biases to get people to trade more frequently?

BOGAN: So they will do things like send push notifications - right? - that will draw attention to the platform and the trading when you're actually not thinking about it. And so it kind of prompts you to trade. And the push notifications can come with a frequency that - it's never rational or reasonable for someone to trade with that frequency.

So when we think about optimal way for most households to think about their investment strategy, buy and hold is usually the conventional wisdom. It's generally never been advantageous for individual households to do day trading and trade, you know, multiple times a day. They also have things like kind of lists of the most traded stocks on the platform. Now, that list isn't providing any specific information about how these companies are valued or should be valued. It's just drawing attention to, other people have traded these stocks. And so those types of lists can also prompt people to - you know, oh, I might be missing out, or everybody else is doing that. So some of those, you know, herd behavior or FOMO biases that can be relevant in a bubble situation could also be triggered by some of these types of ways that these brokers have set up their user interface.

GARCIA: OK. So to summarize, it's good for people to be able to participate in financial markets and to take some risk. Because no risk, no reward. But once you are participating, you should take care to understand exactly how much risk you really are taking. Because if you buy something that's in a bubble, then you might be taking more risk than you realize. And these apps compel you to do just that if you're not careful.

BOGAN: And I think it just highlights the - one of the fundamental points that people need to keep in mind when making any type of investment decision, is to try to make the decision based on their valuation and fundamentals and not be so driven by, you know, what everybody else is doing, what's going on right now. Have a long-term investment perspective and try to think about investing over a long-time horizon.

GARCIA: Right. Be smart. Do your homework. Do your research. And by the way, are there any behavioral biases that we should be mindful of that can help us do that better?

BOGAN: The other bias that I think people need to be cautious about and aware of is something called confirmation bias. And so that's where we seek information that kind of supports our view and ignore or discount information that runs counter to our view. So if you go into a situation where you're going to research a company and you're trying to get information to decide whether you're going to invest, you may only seek out information that supports what you think you should do. Oh, I think I should buy this, so let me research this company. And you would only seek out information that lets you know or suggests that the company is a good company. And if you find something that says that maybe there's some caution flags or red flags, you just discount that. Oh, that's not as important. And so in my own personal research, I've found that confirmation bias is an important bias to be aware of when making an investment and making financial decisions.

GARCIA: And I think that's a great place to wrap up. You know, we all live through bubbles at some point in our lives, maybe even big ones. So don't make frantic decisions because that can be a source of deep regret later on. So make sure you're aware of these biases so that you can take a smart mental approach to your investments. Well, Vicki, it has been such a pleasure having you as a Summer School professor. Thank you so much.

BOGAN: I appreciate that. Thanks. It was a lot of fun.

(SOUNDBITE OF FREDERIC AUGER AND FLORIAN GAZAN'S "CROISETTE BALADE")

GARCIA: And before we let our listeners go, we do have some vocab words for you. First up, the greater fool theory, which is when you buy something that you know is overpriced, but you think you'll be able to sell it to the next sucker for an even higher price. Also, there's a couple of behavioral biases that make us susceptible to investing in a bubble and thereby continuing to fuel that bubble - excessive optimism - when we underweight the risk of something bad happening, and herd behavior - we are hardwired to act like everyone else around us is also acting - and finally, confirmation bias - when we look for information that confirms what we already believed and discount information that contradicts those beliefs.

This is Season 2 of PLANET MONEY Summer School. Be sure to come back for Episode 6, our final graduation episode. We've got all kinds of fun stuff planned.

PLANET MONEY Summer School is produced by Audrey Dilling with help from Alexi Horowitz-Ghazi, Isaac Rodrigues and Serena Golden. It is edited by Alex Goldmark. Our project manager is Devin Mellor, and special thanks to Liana Simstrom. I'm Cardiff Garcia, and I'm also the host of my own podcast, "The New Bazaar," to which you can now subscribe at all the usual podcast places. PLANET MONEY is a production of NPR. Thanks for listening.

(SOUNDBITE OF FREDERIC AUGER AND FLORIAN GAZAN'S "CROISETTE BALADE")

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