Investors’ Fear of Missing Out on Disruptive Technology Leads to Overvalued Stocks
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Finance & Accounting Oct 4, 2017

Investors’ Fear of Miss­ing Out on Dis­rup­tive Tech­nol­o­gy Leads to Over­val­ued Stocks

Think of it like health insur­ance” for your portfolio.

Investors bet on a new technology.

Michael Meier

Based on the research of

Leonid Kogan

Dimitris Papanikolaou

Noah Stoffman

Is Tes­la the next Amazon? 

Stock mar­ket investors would love a crys­tal ball that sup­plies the answer. After all, Ama­zon end­ed up utter­ly dom­i­nat­ing the nascent e-com­merce busi­ness it helped define, reduc­ing its com­peti­tors to dot-com punch lines, bank­rupt­cy, or both. 

Today, Tes­la is try­ing to do the same thing for elec­tric and self-dri­ving cars. But there’s no way to tell if Elon Musk’s start­up will be the Ama­zon of its domain, or the Pets​.com (remem­ber them?). Still, that has not stopped investors from pay­ing extreme­ly high prices—some would say irra­tional­ly high prices—for a stake in the firm. 

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This sort of seem­ing­ly irra­tional investor behav­ior does not just apply to mod­ern high-tech companies.

One of the most endur­ing puz­zles in finance is this fact that so-called growth stocks’ are typ­i­cal­ly over­val­ued rel­a­tive to some mea­sure of fun­da­men­tals, and have very low returns,” says Dim­itris Papaniko­laou, an asso­ciate pro­fes­sor of finance at the Kel­logg School. This pat­tern has being ongo­ing for about a hun­dred years — as far back as we have stock mar­ket data.”

The ques­tion is: Why?

If peo­ple have this fear of miss­ing out or being left behind, they will view invest­ing in some­thing like Tes­la as a way of hedg­ing against future dis­rup­tions and inequality,” 

Accord­ing to Papaniko­laou, econ­o­mists have tra­di­tion­al­ly chalked up this phe­nom­e­non — known as the val­ue pre­mi­um puz­zle” — to inef­fi­cien­cy and irra­tional­i­ty in the mar­ket­place: peo­ple are just con­sis­tent­ly mak­ing mis­takes, and that’s all there is to it.”

But a cen­tu­ry is a long time for investors to not learn their les­son. What if their ten­den­cy to over­price” growth stocks was actu­al­ly a ratio­nal response to some oth­er fac­tor — like the unpre­dictable effects of tech­no­log­i­cal innovation?

How Cre­ative Destruc­tion Spurs Over­val­ued Stocks

With col­lab­o­ra­tors Leonid Kogan at MIT and Noah Stoff­man at Indi­ana Uni­ver­si­ty, Papaniko­laou set out to cre­ate an eco­nom­ic mod­el that could explain the val­ue pre­mi­um puz­zle by account­ing for the dis­rup­tive effects of inno­va­tion, which he refers to as cre­ative destruction. 

When a new game-chang­ing tech­nol­o­gy — for exam­ple, high-speed house­hold Inter­net ser­vice — appears on the eco­nom­ic scene, some com­pa­nies ben­e­fit much more in the short term than oth­ers, which may end up, essen­tial­ly, destroyed. 

Take Net­flix ver­sus Blockbuster.

Net­flix takes advan­tage of faster Inter­net and then Block­buster is not worth as much any­more, because who wants to go to the store to rent a movie when it’s freez­ing out?” Papaniko­laou explains. So in rel­a­tive terms, the improve­ment in tech­nol­o­gy ben­e­fit­ed Net­flix much more than Blockbuster.”

And while it seems hard to remem­ber this, once upon a time we did not instinc­tive­ly know that Block­buster would be the los­er in that race.

Cre­ative destruc­tion, with its unpre­dictable win­ners and losers, not only has the poten­tial to rede­fine entire indus­tries — it can also gen­er­ate extreme­ly out­sized wind­falls for the win­ners, while the losers get left out.

As an exam­ple, Papaniko­laou uses self-dri­ving cars: a poten­tial­ly world-chang­ing inno­va­tion if there ever were one.

Right now we don’t know who’s going to per­fect the self-dri­ving car and even­tu­al­ly bring it to mar­ket; it could be Tes­la, or it might be some oth­er com­pa­ny,” he says. But who­ev­er it is, the finan­cial ben­e­fits from that inno­va­tion are going to go dis­pro­por­tion­ate­ly to the Elon Musks of the world. Because oth­er­wise, they wouldn’t have both­ered to put any effort into per­fect­ing the cars in the first place.”

So investors know that the win­ning” inno­va­tor will make a for­tune, as will the investors who were smart or lucky enough to pick that innovator’s com­pa­ny. Those who did not bet on the right com­pa­ny will lose out on that wind­fall — a fate investors want to avoid.

Under­stand­ing Seem­ing­ly Irra­tional Investor Behavior

These unpre­dictable indus­try effects and mas­sive poten­tial income dis­par­i­ties cre­ate a pow­er­ful incen­tive for investors to pro­tect them­selves against being left behind.

If peo­ple have this fear of miss­ing out or being left behind, they will view invest­ing in some­thing like Tes­la as a way of hedg­ing against future dis­rup­tions and inequal­i­ty,” he explains. After all, in the face of the uncer­tain­ties wrought by self-dri­ving car tech­nol­o­gy, isn’t it smarter to over­pay now for Tes­la stock as part of a port­fo­lio of oth­er poten­tial self-dri­ving-car stocks, than to sit on your hands and lose big later?

Think of it like health insur­ance,” Papaniko­laou explains. The aver­age per­son is over­pay­ing’ in the sense that, if you added up all the pay­ments you make to the insur­ance com­pa­ny ver­sus all the med­ical claims over your life­time, you’re most like­ly los­ing mon­ey. But you’re still hap­py to do it — just in case some­thing unpre­dictable hap­pens, so you don’t get stuck with a hos­pi­tal bill for a cou­ple hun­dred thou­sand dollars.”

Unlock­ing the Val­ue Pre­mi­um Puzzle

A nov­el part of Papanikolaou’s mod­el, he says, is the assump­tion that, while inno­va­tion is usu­al­ly a net eco­nom­ic pos­i­tive, it does not show­er ben­e­fits onto all par­tic­i­pants in the econ­o­my equal­ly. Most eco­nom­ic mod­els, he says, do not real­ly take into account the dis­parate impacts of a dis­rup­tive tech­nol­o­gy on firms and indi­vid­ual investors.

Inno­va­tion will dis­place or replace or dis­rupt some­thing that’s already here. This is in con­trast to the more tra­di­tion­al way of mod­el­ing it, which is very uni­form — you have bunch of cap­i­tal and you have a bunch of work­ers and this mag­ic inno­va­tion’ hap­pens and then sud­den­ly every­thing is more productive.”

The researchers built their mod­el with three main assump­tions — that tech­no­log­i­cal inno­va­tion ben­e­fits some firms and dis­ad­van­tages oth­ers; that the lion’s share of ben­e­fits accrues to insid­ers at the inno­vat­ing firms (as opposed to share­hold­ers); and that investors are moti­vat­ed to hedge against future income inequality.

Then they com­pared the model’s out­put with real eco­nom­ic data from the past cen­tu­ry, which includ­ed aver­age GDP growth, ratios of invest­ment to out­put, and dif­fer­ences in prof­itabil­i­ty and rates of inno­va­tion across firms.

The ver­dict? The out­put of the mod­el looks rea­son­able,” he says, which implies that our expla­na­tion is plau­si­ble, too”.

Take­aways for Investors

Papaniko­laou cau­tions that this mod­el of cre­ative destruc­tion is not a bul­let­proof grand uni­fied the­o­ry” for how tech­no­log­i­cal inno­va­tion affects indus­tries, or how the gains from those inno­va­tions are mas­sive­ly asym­met­ri­cal among investors.

But he says the results have use­ful impli­ca­tions for investors and house­holds as tech­no­log­i­cal inno­va­tion accelerates.

For exam­ple, invest­ing in mutu­al funds in order to beat the stock mar­ket might not be the right bench­mark,” he says. What that means, tech­ni­cal­ly speak­ing, is that you’ll most­ly be invest­ing in val­ue stocks and under-weight­ing growth stocks. So yes, it’s maybe true that you’re beat­ing the mar­ket, but it isn’t free mon­ey. It bears a cost” — the cost of miss­ing out on the next Amazon.

Pay­ing hun­dreds of dol­lars per share for Tes­la is cost­ly, too. But the peace of mind it pro­vides investors as part of an insur­ance pol­i­cy against cre­ative destruc­tion may be worth it in the end. And it may have been fuel­ing mar­ket behav­ior for the past century. 

About the Writer

John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.

About the Research

Kogan, Leonid, Dimitris Papanikolaou, and Noah Stoffman. 2013. "Winners and Losers: Creative Destruction and the Stock Market." Working paper.

Read the original

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