Friday, September 19, 2008

Last, Latest, Young Investors (fg)

Or: Who takes the losses when a bubble bursts and who learns the lessons?

Well, everbody knows it: there are ups and downs in financial markets, excess positive and negative returns, gains and losses, pessimism and optimism - and in the end, at least on average, market efficiency holds.

Well, everbody knows: too much leverage may do damage to financial markets and balance sheets; we all heard about the balance sheet and credit channel of monetary policy.

Well, everybody knows: when the bubbles burst, somebody has to take the losses since only few can leave the wave before it crashes.

Recent research shows that it's mainly young portfolio managers who try to ride the bubble; meanwhile more experienced managers wait until the bubble bursts to invest in assets. Taken together, the facts are consistent with the popular view that inexperienced investors are susceptible to buy assets with inflated prices druing bubble periods:
We use mutual fund manager data from the technology bubble to examine the hypothesis that inexperienced investors play a role in the formation of asset price bubbles. Using age as a proxy for managers' investment experience, we find that around the peak of the technology bubble, mutual funds run by younger managers are more heavily invested in technology stocks, relative to their style benchmarks, than their older colleagues. Furthermore, young managers, but not old managers, exhibit trend-chasing behavior in their technology stock investments. As a result, young managers increase their technology holdings during the run-up, and decrease them during the downturn. Both results are in line with the behavior of inexperienced investors in experimental asset markets. The economic significance of young managers' actions is amplified by large inflows into their funds prior to the peak in technology stock prices.

You find the paper on the NBER website. It is written by Greenwood and Nagel. It may also give an idea why we economists often wonder why in general investors do not learn lessons from past exuberances (since we often do not see it in the data) and young traders may play a significant role in that process.