The widespread adoption of new technologies – from the automobile to the Internet – tends to be accompanied by stock market booms and busts. Why do the stock prices of innovative firms tend to exhibit apparent “bubbles” during technological revolutions?
During technological revolutions, stock prices of innovative firms tend to exhibit bubble-like patterns. After an initial surge, stock prices usually fall in the presence of high volatility, as they did during the “biotech revolution” of the early 1980s and the Internet craze of the late 1990s.
While the bubble-like stock price behaviour is commonly attributed to the irrationality of overenthusiastic investors, why would investors make the same mistake over and over again? In our recent study titled “Technological Revolutions and Stock Prices,” we propose the first rational explanation for why stock prices should be expected to exhibit a bubble during a technological revolution – a period concluded by a large-scale adoption of a new technology. Our explanation for the bubbles is that the nature of risk associated with new technologies changes over time.
Uncertainty about productivity gains is a natural feature of innovative technologies. At first this uncertainty, or risk, is mostly “idiosyncratic,” because the new technology is initially developed on a small scale and the probability of large-scale adoption is low. For new technologies that become widely adopted, the uncertainty gradually changes from idiosyncratic to “systematic.” When systematic risk increases, prices decline. These increases in systematic risk can be expected in hindsight, by researchers who look back knowing that the revolutions took place, but they are unexpected by real-time investors who do not know whether the new technology will eventually be adopted on a large scale or not.
The “bubbles” should be most pronounced in revolutions characterised by high uncertainty about, and fast adoption of, the technology – such as the recent Internet revolution.
We developed an economic model to provide a rational explanation for stock price movement during technological revolutions. To test our model, we examined stock prices in 1830–61 and 1992–2005, the respective periods when railroad and Internet technologies spread in the United States. Bubbles are not merely possible in a rational world, but should be expected during technological revolutions.
the changing nature of risk
In order to explain how stock prices should behave during technological revolutions, we developed what economists call a “general equilibrium model.” In the model, investors study the productivity of a new technology, and must decide whether adopting this new technology on a large scale would be worthwhile. Large-scale adoption would constitute a technological revolution. We determine the optimal time for adopting the new technology and show that when the technology is optimally adopted, there should be bubbles in stock prices.
During technological revolutions, stock prices of innovative firms tend to exhibit bubble-like patterns. After an initial surge, stock prices usually fall in the presence of high volatility, as they did during the “biotech revolution” of the early 1980s and the Internet craze of the late 1990s.
While the bubble-like stock price behaviour is commonly attributed to the irrationality of overenthusiastic investors, why would investors make the same mistake over and over again? In our recent study titled “Technological Revolutions and Stock Prices,” we propose the first rational explanation for why stock prices should be expected to exhibit a bubble during a technological revolution – a period concluded by a large-scale adoption of a new technology. Our explanation for the bubbles is that the nature of risk associated with new technologies changes over time.
Uncertainty about productivity gains is a natural feature of innovative technologies. At first this uncertainty, or risk, is mostly “idiosyncratic,” because the new technology is initially developed on a small scale and the probability of large-scale adoption is low. For new technologies that become widely adopted, the uncertainty gradually changes from idiosyncratic to “systematic.” When systematic risk increases, prices decline. These increases in systematic risk can be expected in hindsight, by researchers who look back knowing that the revolutions took place, but they are unexpected by real-time investors who do not know whether the new technology will eventually be adopted on a large scale or not.
The “bubbles” should be most pronounced in revolutions characterised by high uncertainty about, and fast adoption of, the technology – such as the recent Internet revolution.
We developed an economic model to provide a rational explanation for stock price movement during technological revolutions. To test our model, we examined stock prices in 1830–61 and 1992–2005, the respective periods when railroad and Internet technologies spread in the United States. Bubbles are not merely possible in a rational world, but should be expected during technological revolutions.
the changing nature of risk
In order to explain how stock prices should behave during technological revolutions, we developed what economists call a “general equilibrium model.” In the model, investors study the productivity of a new technology, and must decide whether adopting this new technology on a large scale would be worthwhile. Large-scale adoption would constitute a technological revolution. We determine the optimal time for adopting the new technology and show that when the technology is optimally adopted, there should be bubbles in stock prices.
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