Stop Investing in What You Know

SMITH BRAIN TRUST – People love a great story. So when a new technology comes to market with the promise of a happy ending, early adopters jump at the chance to invest in something they know. That’s a rookie mistake, entrepreneurship professors Brent Goldfarb and David A. Kirsch write in their new book, Bubbles and Crashes: The Boom and Bust of Technological Innovation.

“Be very careful about investing in something that you use or that seems exciting because you see it in the world around you,” Goldfarb says. “You may think, 'Huh, I know this is going to be useful in some way.' But you may under appreciate how difficult it will be to make money using that technology.”

The distinction between useful and profitable is key. “Those are two very different things,” he says.

Goldfarb and Kirsch, both professors at the University of Maryland’s Robert H. Smith School of Business, present a model for predicting speculative bubbles based on their study of 58 historical cases, ranging from the commercialization of vulcanized rubber in 1840 to the hovercraft in 1955. Then the authors test their model using 30 modern cases.

In every situation where bubbles emerge, the authors find retail investors inserting themselves into a compelling story because they like the underlying product or service — or they trust the vision of leaders who look into the future and see something wonderful.

Kirsch sees retail investors falling into that trap with Tesla. They love the story of electric vehicles and appreciate the vision of Tesla CEO Elon Musk, so they open their wallets.

“But you might underestimate how hard it will be to actually build a factory that assembles the cars in an efficient and reliable way, and then yields returns to shareholders,” Kirsch says. “Or you might live in Palo Alto and look around and see everyone driving a Tesla, so you think, ‘This company must really be taking off. I better go and buy stock in it.’”

Unfortunately, Kirsch says, people can know cars without knowing the car market or operational challenges. They also tend to underestimate the competitive dynamics that squeeze profit margins as markets scale up.

“You don’t realize that it’s actually a very narrow market segment that you're observing, and that the mass market might be some years away and not nearly as accessible as you might think just by looking around,” Kirsch says.

Goldfarb gives the example of social-planning websites that let people create and send electronic invitations. When consumers saw the earliest renditions of these platforms in the 1990s, they recognized the usefulness of the service and invested millions of dollars.

“All those investors lost money because it turns out it's hard to monetize electronic invitations,” Goldfarb says.

That doesn’t mean novice investors will never make money when they invest in what they know. But they should pause and consider the path to profit, which might be decades away. Goldfarb recommends one additional precaution.

“If you’re a retail investor and you’re thinking of investing in a new technology or new speculative industry, the first thing you should do is go to Amazon and buy our book,” he says. “Then you should read it.”