Tulip Fever: Insights and Implications

Disciplined Equity

Tulip Fever: Insights and Implications

Dutch tulips, Internet stocks, condo flipping—examples all of famous bubbles. Even Hollywood is getting in on the action, with a period drama “Tulip Fever” just released. And why not? It’s the perfect story of red-hot emotion running up against cool reason. These examples show that markets can be swept up by emotion, fascinated by fads, and wildly inefficient. The sources of this inefficiency are enduring investor behavioral biases, which are deeply rooted in individual psychology. We believe this creates opportunities for active portfolio managers to outperform their benchmarks.

Enduring Investor Bias

A well-known investor bias is the tendency to overreact to good or bad news, and to extrapolate past performance too far into the future. So, for example, tulips may look like a great buy today because their price just goes up the next day, or value names tend to be beaten down too much because they just seem to get cheaper. In a classic 1994 article, Lakonishok, Shleifer and Vishny1 showed that prices of stocks that had strong fundamental growth in recent years tended to react as if that growth would persist far into the future. Markets tend to discount other explanations, such as luck, entrance and exit of competitors, and the tendency of growth to revert to the mean (average), among other factors.

Another example is that investors tend to underreact to certain fundamentally relevant bits of information, either because of inattention or because the information is too complex or costly to acquire and process, such as linkages across geographies or supply chains. McDonald’s is viewed as a quintessentially American company, but more than half of its revenues are derived from overseas. So if the U.S. economy isn’t doing as well than others, McDonald’s should actually perform better than more domestically focused peers. But this information may not be widely appreciated or available.

Or consider that investors consistently tend to fixate on certain specific fundamental variables and ignore others that are also relevant. Investors generally focus on reported earnings and pay less attention to cash flows, even though cash flows have historically been, on average, more informative about future fundamentals, including future earnings.

We can show these biases at work in a well-known “story” stock. Netflix is immortalized as the “N” in the “FANG” stocks (Facebook, Amazon.com, Netflix, and Google, which was renamed Alphabet). Look back to 2015, when Netflix’s stock more than doubled in value through about December on the promise of rising subscriber growth and expansion into non-U.S. markets. But another, truly remarkable reason cited for the stock’s gain at the time was the fact that the company executed a seven-for-one stock split that summer.

To be clear, stock splits have absolutely zero impact on corporate fundamentals, but the stock went up anyway because it appeared to be cheaper to small investors. Of course, we know that when those expansion plans disappointed, costs for content surged, and competition intensified, the stock fell by more than a third from December 2015 to February 2016. Netflix and the other examples cited here are powerful evidence of the significant and enduring biases at work in the market every day, which create mispricings and opportunities for active investment approaches to generate outperformance.

Evidence Over Emotion

Capitalizing on the cognitive errors of others while minimizing biases is one way to win at the zero-sum game of active portfolio management. The aim of this approach is to generate solid long-term performance by removing human emotion and bias from the investment process—no quantitative process we know of has yet succumbed to tulip fever.

1Lakonishok, Josef, Andrei Shleifer, and Robert W Vishny. 1994. “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance 49 (5): 1541-1578.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

The opinions expressed are those of Vinod Chandrashekaran, Ph.D., and are no guarantee of the future performance of any American Century Investments portfolio

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.