Riding Bubbles

by
Erik Kole
Nadja Guenster
Ben Jacobsen

LINK

Abstract:
"Theoretical studies have yet to reach consensus on a rational investor's optimal response to asset price bubbles. Their predictions vary between going short, sidelining, and riding bubbles. We document patterns in U.S. industry returns that support riding bubbles as an optimal response, consistent with the theory of Abreu and Brunnermeier (2003). An investor who rides bubbles can earn abnormal returns in the order of 0.41% to 0.64% per month. However, these high returns come at the expense of a high crash risk: upon the detection of a bubble, the risk of a crash more than doubles. We evaluate the asset allocation implications of this tradeoff in a mean-downside risk framework. The additional return an investor can earn by riding a bubble more than offsets the higher risk of a crash".


"We rely upon two main characteristics of bubbles, described for example
by Abreu and Brunnermeier (2003): (1) the growth rate of the price is higher than the
growth rate of fundamental value and (2) the growth rate of the price experiences a sudden acceleration".

Crash likelihood increases upon the detection of a bubble. Depending on the exact model specication, the probability of a crash in the following months more than doubles.

The authors find that additional return an investor can earn by riding a bubble more than outweighs the risk of a crash.

In the figure you can see for each month the number of industries which are in a bubble