Maryland Smith Authors Crack Code to Financial Bubbles

New Book Identifies Four-Factor Model for Predicting Next Crash

COLLEGE PARK, Md. (Feb. 19, 2019) — Beware of a great story when picking stocks, authors Brent Goldfarb and David A. Kirsch write in their new book, “Bubbles and Crashes: The Boom and Bust of Technological Innovation,” released today from Stanford University Press.

“Our work puts the role of narrative at center stage,” write the authors, both entrepreneurship professors at the University of Maryland’s Robert H. Smith School of Business. “We cannot understand real economic outcomes without also understanding when the stories that influence decisions emerge and under which conditions they are most likely to be created.”

Goldfarb and Kirsch base their findings on an examination of 58 historical cases, ranging from vulcanized rubber in 1840 to the hovercraft in 1955.

They observe when economic bubbles occur, but also when they don’t. They look at contemporaneous press coverage and historical accounts. And they consider the context of available market institutions from the unregulated days of curbside trading outside the New York Stock Exchange to the modern era.

What emerges is a four-factor model for predicting disaster, which the authors test on 30 recent cases. In every instance, the same four conditions help separate wild speculation from reasonable risk-taking.

Uncertainty: Bubbles start with uncertainty surrounding a new invention or breakthrough. The underlying technology may be solid, but questions remain about how to commercialize it. Investors who wait for clarity may be late to the game, so they place their bets early before anyone knows an asset’s real value.

Alignment of beliefs: How investors place their bets depends largely on the story they choose to accept. High-profile events, amplified in the media, often serve to coordinate beliefs around one particular narrative. “These stories piece together different facts, ideas and guesses about a new technology and its potential profitability,” Goldfarb and Kirsch write.

Pure plays: Firms tightly coupled to the commercial fate of the new technology are called “pure plays.” These companies allow investors to buy into a narrative literally. “Pure plays make good stories,” Goldfarb and Kirsch write. “Given an interest in, say, electric vehicles, it is more exciting to invest in Tesla than in General Motors, despite the fact that both companies are deeply involved in the electrification of transportation.”

Novice investors: All of these factors combine to attract novice investors, the fourth piece in the bubble equation. Goldfarb and Kirsch say these retail or “noise traders” are especially likely to invest when new technology is relatable to them — like the internet — even if they don’t know how anyone might profit from it.

Despite cycles of boom and bust going back as far as markets have existed, Goldfarb and Kirsch say investors continue to misread the warning signs. “Our inability to avoid bubbles suggests that our understanding of them is incomplete,” they write. “Our book helps close the gap.”

Goldfarb is the academic director of the Dingman Center for Entrepreneurship at Maryland Smith and has a PhD in economics from Stanford University. Kirsch has a PhD in history from Stanford and is also the author of “The Electric Vehicle and the Burden of History” (Rutgers University Press, 2000).