Arnold Kling  

Are Small Investors Irrational?

Comment of the Week, 2003-07-0... Limits to Growth?...

Hal Varian's column cites research on the irrationality of small investors during the dotcom bubble.

First, there were significant differences of opinion about the value of Internet stocks, with retail investors tending to be much more optimistic than insiders or institutions.

Second, there were significant restrictions on short-selling those stocks, a way of betting that they would decline. This prevented the pessimistic expectations from being incorporated in market prices.

While the paper to which Varian refers, by Eli Ofek and Matthew Richardson, is not on line, a related paper says that

While the fact that the price gets bid up too much in the first place is clearly anomalous, we provide arguments and evidence that the lock-up effect is not arbitrageable. In fact, trading costs, the difficulty of shorting newly-public stocks, and short-term capital gains faced by the original shareholders, all help explain this fact.

I am skeptical of this research. First of all, the estimate of the effect of the lock-up on share prices is only a few percentage points. It does not explain how Internet stocks came to be overvalued by 1000 percent. The challenges on short sales could have been overcome using derivatives. The options exchanges had created indexes of Internet stocks as early as 1996. Buying puts on those indexes, or buying puts on the Nasdaq index as a whole, was a way to bet on the bursting of the Internet bubble that did not suffer from the institutional impediments to short selling.

The other component of the analysis is that small investors allegedly are less rational than professional investors. However, there may be institutional explanations for the observation that the proportion of individual vs. institutional ownership is higher for new stocks than for seasoned stocks.

For Discussion. The crash of 1929 was blamed in part on short selling. This study says that the crash of 2000 should be blamed in part on restrictions on short selling. Which of these analyses, if any, is correct?

COMMENTS (14 to date)
Jim Jinkins writes:


A crash usually comes when enough people realize that a market has become significantly overvalued. It may also come as the result of unexpected, really bad news that affecting market fundamentals.

While regulation, short selling, or general human fear or cussedness may may a crash worse, they can't cause one.

Patrick R. Sullivan writes:

One person who saw the bubble in tech stocks and tried to exploit it by short selling was Stan Liebowitz. He lost a considerable amount of money doing so, as his timing was off. His revenge being his book "Re-Thinking the Network Economy". The introduction can be read at:

Ironically, one of the people coming in for some (mild and polite) criticism for the tech stock bubble is...Hal Varian. For his, and Carl Shapiro's, "Information Rules". Stan quotes assorted stock market analysts and business journalists who got their ideas from somewhere. Such as this from a column in "eCompany":

> "We have the first-mover advantage," CEO Marleen McDaniel told CNBC in June 1999. "They have the first-mover-advantage," a Zona Research analyst told a reporter, explaining why eToy's stock was a steal. "
is an outstanding e-commerce opportunity with a first-mover advantage," Idealab founder Bill Gross bragged in a press release. As Draper Fisher Jurvetson partner Tim Draper told USA Today in October 1999, the first-mover
is "usual the (company) that's going to win it."

Jim Glass writes:

One problem with Varian's analysis is that there is a lot of research that says insider sales aren't nearly as meaningful as insider purchases as an indicator of the value of a stock.

There are lots of reasons for insiders to make stock sales that don't have anything to do with lack of faith in the business.

And this is especially true with IPOs. The insiders may have worked for years building the company with little or no money pay and this is their deferred payday (with a lot of deffered bills to meet) ... at the moment of the IPO they suddenly have way too much of their total wealth in one investment and must diversify, etc. And it's even more true with IPOs that relate to "tech" and "IP" businesses where risk/reward is high, than to IPOs for traditional "old economy" businesses where even if they fail there will be substantial liquidation value, so the differency V notes doesn't surpise me.

In fact, I personally have worked with an investment banker who *required* insiders to sell a significant portion of their holdings when he took their tech company public, or he wouldn't do it.

His reason was to make sure they had enough "safe" personal wealth so that they wouldn't be personally threatened by a fall in the stock price and panic into doing stupid things to get it back up, like a losing gambler who keeps doubling up his bets in a casino all the way into Chapter 7.

So insider sales don't mean that much. OTOH, when insiders use their own money to purchase their own companies' stock, that can be much more significant.

Jane Galt writes:

I would think that Varian might be right, but that the inability of mutual and pension funds to sell short would seem to me to be much more important than the inability of insiders to do so. Savvy investors should have been short on the market long before 2000, but the largest investor class had a statutory mandate to go long.

Bernard Yomtov writes:

Is the inability of some institutions to sell short statutory or self-imposed? (This is an honest question.)

In either case, it hardly creates a "mandate to go long." If a mutual fund thought dot-coms were overvalued it could have sold its holdings, or not bought any, without violating any laws.

The belief that the bubble could have been avoided had "savvy investors" not been prevented from shorting the stocks seems like a stretch. Lots of people - individuals, hedge funds - were not legally prevented from shorting. Most of the constraints were inherent in the market.

And of course this assumes that the short sellers would pick just the right time to act. Despite the crash, you could have lost even more money shorting Internet stocks than buying them if your timing wasn't perfect.

dsquared writes:

Hal Varian's a Berkeley guy, isn't he? As far as I can tell, everyone there (particularly Brad DeLong) who works in financial markets is hung up on this myth of the "big smart investor" who would always pop bubbles early if only they weren't prevented from doing so by some institutional constraint. I personally don't believe in him.

Brian writes:

Jane Galt wrote: "Savvy investors should have been short on the market long before 2000"

Jane Galt, Would you mean savy people like Greenspan and Campbell (Harvard) and Shiller (Yale) who were talking about "irrational exuberance" in December of 1996? If these three smarty pants were short the S&P 500 since that date they would be faced with a 33% loss ((985-740)/740). Or a 29% loss on the NASDAQ ((1663-1291)/1291). Or are you suggesting that these three will yet be vindicated in the coming months?

Brian writes:

Bernard Yomtov, the funds that describe themselves as equity funds have to be substantially long or he can be fired even if the prospectus allows him to hold bonds or 100% cash. He will be fired if the market goes up and he is not heavily in equity because the unitholders want him to be in equity. It is up to the unitholder (and his financial advisor) to lighten up on equity funds when appropriate. It is not the responsibility of an equity fund manager to be anything but an equity fund manager.

Brian writes:

If Arnold Kling has a large readership, it wouldn't make sense to post an answer to the "for discussion" topic. In fact, it does not make sense if there is any readership at all.

Bernard Yomtov writes:


Yes, I understand that. By staying in equities they are doing what they told the investor - their customer - they would do.

My question really was whether there are any legal restrictions on a mutual fund's ability to go short, so long as the possibility is adequately described in the prospectus.

In other words, is the fact that these funds don't usually go short a marketing decision on their part or are they somehow bound by law?

Brian writes:

Bernard, There are equity funds that go short and there are hedge funds which can do anything they want. So I guess the answer is that it is a marketing decision that is made prior to writing the prospectus.

Bernard Yomtov writes:

If so, then the failure of institutions to puncture the bubble early through short selling, assuming they could have punctured it that way, is really just a result of market forces.

So blaming the crash on "restrictions on short selling" doesn't make much sense.

Brian writes:

(Earlier, I somehow ended up calling myself "Bernard" in the "posted by" line. Don't mean to confuse you.--[Econlib Editor Note: This typo has since been fixed: the earlier post now correctly is attributed to Brian.])


I wouldn't say that regulation is completely benign with respect to the creation of extreme valuations. I think there are regulations on the minimum net worth of individuals involved in hedge funds. May be there's no restriction on getting into a short fund but the industry is net long so there's a disincentive to sell such a thing.

Bernard Yomtov writes:


I figured out the name business.

There are net worth limits on getting into hedge funds, and I think they are substantial.

As far as regular mutual funds go, to the extent they could offer "short" funds and don't, it seems they are just reflecting the preferences of individual investors, who generally don't sell short.

But you don't need the whole world going short to keep the bubble from growing. Enough large investors, were able to sell short that they would have an effect. I object to the argument that the whole thing wouldn't have happened if short sellers hadn't been held back by lots of silly rules.

In any case, the restrictions the paper talks about are market-based: unavailabiltiy of stock to borrow, high volatility, etc.

Comments for this entry have been closed
Return to top