Riding the wave, cynically

Most of us know that stocks can become overvalued when too many investors become overoptimistic about the prospects of the company. But an interesting question to ponder is if everyone who piles into a hyped or overvalued stock believes the story that drives the share price. In other words, are people who hold NVidia at current valuations convinced that the AI boom will revolutionise the world? Are people who own Tesla shares convinced that Tesla will one day become the largest car maker in the world by number of cars sold?

Paul Schmitz-Engelbertz and Kaushik Vasudevan used the Investor Confidence Survey of Robert Shiller which has been done monthly since 2001 to tease out what investors thought about other investors’ beliefs. Part of the survey are questions that ask investors if they think other investors think the stock market is overvalued or undervalued.

Equipped with that data, the researchers found that once controlled for the investors’ optimism, when investors perceive other investors as optimistic about the stock market, they tend to invest in the stock market as well. Even if an investor thinks the stock market is overvalued, she buys stocks if she is convinced that other investors are optimistic about the market. That is the definition of cynical investing.

These investors think that stocks will have low returns in the long run, but they ride the wave as long as they can to profit from the unwarranted optimism of other people. Furthermore, when investors perceive others as overly optimistic about the market, share price overreaction to fundamental news increases because positive fundamental news leads to more of these cynical speculators piling into the market trying to ride the wave.

Of course, if the fundamental news is negative, the risk is that investors will become disillusioned with the stock and investors will revise their overly optimistic views. And that is why cynically riding a bubble is so dangerous. Even if an investor knows that a stock is overvalued and share price advances are based on hype, there is always a risk that the herd of investors who believe the story will turn and run in a different direction before the cynical investor can get out. If one invests based on the forecast of other people’s beliefs, then one needs to be able to forecast other people’s mood swings. And I for one am unable to do that which is why I rather stay on the sideline when I have to deal with overhyped and overvalued stocks.