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How The “Dumbest Theory” Works That Can Lead You To Make Wrong Financial Decisions (And What It Has To Do With Bubbles)

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It works like this you can make money if you buy a stock that is overvalued because there will always be someone dumber willing to pay a higher price. This theory works as long as you can sell at a higher price than you bought. The problem is that if you did not sell on time, that is, before the price fell, there will be no others dumber than you.

You can lose all your money if you keep stocks that nobody wants to buy, says Vicki Bogan, a professor at Cornwell University in New York. It is a very risky theory that is put into practice when there are bubbles in the market, he says in dialogue with bubbles understood as explosions of irrationality where the price of an asset increases dramatically, exceeding what economists call its intrinsic or essential value. It has happened countless times throughout history from the crash of 1929 to the toxic mortgages of the Great Financial Crisis. But even much further back. The first massive speculative bubble in world history was the tulip mania in the Netherlands in the 17th century when there was a collective euphoria over the purchase of exotic tulips. The price of flower bulbs reached such exorbitant levels that people sold their houses to get them and in the midst of the euphoria even a market for future sales was created from unharvested bulbs.

However, the frantic escalation found its end, when one day in 1637, the price collapsed and the Dutch economy went bankrupt. Another well-remembered case in recent history was the dot-com bubble when towards the end of the 90s the value of some technology firms reached astronomical levels despite the fact that they had no real income. From a rational point of view, Bogan explains, you wouldn’t buy something knowing you’re paying an overpriced price. But from the point of view of the dumbest theory, it is rational to buy at an excessive price because there will be someone else who will buy more expensive. It is a speculative decision because the investor is sure that he can make money in a certain window of time.

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The difficult thing is knowing when to enter and when to leave the game in time so as not to become the dumbest. The most recent bubble is GameStop says the economist.No one thought that company had any prospects of being profitable in the long term, he adds, but there was a coordinated effort by retail investors on the social network Reddit to get many people to buy its stock, causing a gigantic price increase. Warning signs problem with bubbles is that you only have the certainty that we are dealing with one of them when they burst, says John Turner, professor at Queen’s University Belfast and co-author of the book Rise and Fall: A Global History of Financial Bubbles.

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However, certain warning signs can be identified associated with the bubbles he explains in dialogue with One of them is the appearance of assets that become very salable in the style of what happened with. Another occurs when many amateur speculators enter the stock markets. And it is also a red flag when interest rates are very low and then it is very easy to borrow money, as it is now in the financial markets. If we look at technology stocks in the United States, green technology stocks, bitcoin, we can think that there is potentially a bubble in those assets, says Turner in dialogue.

Not all bubbles have great repercussions at the systemic level, but some can turn into bombs. It can be very dangerous when there is money coming from loans in the bubble because it can have ramifications for the banking system and the rest of the economy, which are quite horrible, as we saw in the financial crisis of 2008.”The big puzzle, he adds, is figuring out what’s really going on with the stock markets, which have boomed during the pandemic. Some economists are waiting for a strong correction in the markets as equity returns have exploded amid one of the worst economic crises in decades in the wake of the Covid-19 pandemic. Although not everyone agrees.

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Almost everyone points to the stock markets to signal the existence of a bubble. I am not convinced that this is true Jason Reed, a professor in the Department of Finance at the University of Notre Dame, tells. From his perspective, the red flags are coming from the side of bitcoin, whose price has accelerated to the point where the currency functions as a speculative asset rather than a substitute for the sovereign currency. We will see more volatile prices, but without real systemic macroeconomic consequences, he says. Although that does not mean there were no injuries in the battle. Individual retail investors could face real economic damage and this is something worth noting and exploring. The fools are many”Veljko Fotak, a professor in the Department of Finance at the University of Buffalo School of Management in New York, cautions that the dumbest theory has a big problem.

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This theory creates the impression that a large number of investors benefit from buying overvalued assets while a small group of losers or a lonely fool is left broke when the party is over. But in practice, Fotak points out, the game doesn’t work that way. The group of losers in most cases is the overwhelming majority of investors he tells For this and other reasons the economist declares himself a skeptic of the dumbest theory. Kotak contends that the evidence shows that you are more likely to lose than win when you buy an asset that is overvalued. And one of the traps is that it is very difficult to identify the loser. They say that among poker players it is often said that if you don’t know who the fool is at the table, get up. You are the fool.

Investing in the hope that someone will make even bigger mistakes seems. well silly he says. In general, he says, markets “offer asymmetrical rewards, with few winners profiting handsomely and a larger group suffering losses. Perhaps I would be more sympathetic to the theory if they called it the Many Dumber Theory. The Wall Street Bubble” Kotak argues that there are different types of assets whose market valuations have been distorted by the lax monetary policies of the last decades and the strong interventions of the central banks during the last year, in the middle of the covid-19 pandemic.

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But none stand out as much as the US stock markets. For example, one of the measures used to assess whether a price is overvalued is the price-to-earnings, (PE), developed by the Nobel laureate in economics Robert Shiller. If we apply this methodology to the companies that belong to the S & P500 index, explains the economist, we obtain a ratio slightly above 40.

What does that mean? In the last century, that ratio has been around 15 or 16. There were only two other cases where we’ve seen that higher rate Fotak says. In 2009, right at the beginning of the global financial crisis, and, before that in 2001, right before the deflation of the dot-com bubble. Thus the historical precedents are not encouraging says the economist. While the stock market is where the bubble is most visible no asset class is immune he adds. But what worries him most is the irrational exuberance in the debt markets. A lot of parallels can be drawn between the mortgage markets of the early 2000s and the corporate debt markets of the last five years he says.

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“The debt markets worry me above all because any shock tends to cause contagion and risks of destabilization of the financial system, which, in turn, affects all sectors of the economy. If in the future there is a fall in the price of shares, which is what happens when a bubble bursts, that causes an immediate loss of confidence in the financial markets. This loss of confidence, Fotak argues, translates into lower savings and investment rates in subsequent years, with effects that can span entire generations. In turn, this leads to a capital shortage that can negatively affect growth rates and employment levels for decades to come. It is not a game like a poker. And there is not a small group of losers who can be characterized as the dumbest.

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