THE JOURNAL OF FINANCE.VOL.XLV,NO.2.JUNE 1990 Positive Feedback Investment Strategies and Destabilizing Rational Speculation J.BRADFORD DE LONG,ANDREI SHLEIFER,LAWRENCE H.SUMMERS, and ROBERT J.WALDMANN* ABSTRACT Analyses of rational speculation usually presume that it dampens fluctuations caused by "noise"traders.This is not necessarily the case if noise traders follow positive- feedback strategies-buy when prices rise and sell when prices fall.It may pay to jump on the bandwagon and purchase ahead of noise demand.If rational speculators'early buying triggers positive-feedback trading,then an increase in the number of forward- looking speculators can increase volatility about fundamentals.This model is consistent with a number of empirical observations about the correlation of asset returns,the overreaction of prices to news,price bubbles,and expectations. WHAT EFFECT DO RATIONAL speculators have on asset prices?The standard answer,dating back at least to Friedman(1953),is that rational speculators must stabilize asset prices.Speculators who destabilize asset prices do so by,on average, buying when prices are high and selling when prices are low;such destabilizing speculators are quickly eliminated from the market.By contrast,speculators who earn positive profits do so by trading against the less rational investors who move prices away from fundamentals.Such speculators rationally counter the devia- tions of prices from fundamentals and so stabilize them. Recent work on noise trading and market efficiency has accepted this argument (Figlewski,1979;Kyle,1985;Campbell and Kyle,1988;DeLong,Shleifer,Sum- mers,and Waldmann,1987).In this work,risk aversion keeps rational speculators from taking large arbitrage positions,so noise traders can affect prices.Nonethe- less,the effect of rational speculators'trades is to move prices in the direction of,even if not all the way to,fundamentals.Rational speculators buck noise- driven price movements and so dampen,but do not eliminate,them. In this paper we present a possibly empirically important exception to this argument,based on the prevalence of positive feedback investors in financial markets.Positive feedback investors are those who buy securities when prices rise and sell when prices fall.Many forms of behavior common in financial markets can be described as positive feedback trading.It can result from extrap- olative expectations about prices,or trend chasing.It can also result from stop- loss orders,which effectively prompt selling in response to price declines.A De Long is from Harvard University and NBER;Shleifer is from University of Chicago and NBER;Summers is from Harvard University and NBER;Waldmann is from European University Institute.We would like to thank the Russel Sage and Alfred P.Sloan Foundations for financial support and Robert Barsky,Oliver Hart,Kevin Murphy,Jeremy Stein,Hans Stoll,Rene Stulz,and Robert Vishny for helpful comments. 379 Copyright O 2001 All Rights Reserved
380 The Journal of Finance similar form of positive feedback trading is the liquidation of the positions of investors unable to meet margin calls.Positive feedback trading is also exhibited by buyers of portfolio insurance,who might engage in this practice because their willingness to bear risk rises sharply with wealth(Black,1988). In the presence of positive feedback traders,rational speculation can be destabilizing.When rational speculators receive good news and trade on this news,they recognize that the initial price increase will stimulate buying by positive feedback traders tomorrow.In anticipation of these purchases,informed rational speculators buy more today,and so drive prices up today higher than fundamental news warrants.Tomorrow,positive feedback traders buy in response to today's price increase and so keep prices above fundamentals even as rational speculators are selling out and stabilizing prices.The key point is that,although part of the price rise is rational,part of it results from rational speculators anticipatory trades and from positive feedback traders'reaction to such trades. Trading by rational speculators destabilizes prices because it triggers positive feedback trading by other investors. This view of rational speculation has been motivated in part by George Soros' (1987)description of his own investment strategy.Soros has apparently been successful over the past two decades by betting not on fundamentals but,he claims,on future crowd behavior.Soros finds clear examples of the trading opportunities he seeks in the 1960's conglomerate and the 1970's Real Estate Investment Trust(REIT)booms.1 In his view,the 1960's saw a number of poorly informed investors become excited about rises in the reported annual earnings of conglomerates.The truly informed investment strategy in this case,says Soros, was not to sell short in anticipation of the eventual collapse of conglomerate shares(for that would not happen until 1970)but instead to buy in anticipation of further buying by uninformed investors.The initial price rise in conglomerate stocks,caused in part by purchases by speculators like Soros,stimulated the appetites of uninformed investors since it created a trend of increasing prices and allowed conglomerates to report earnings increases through acquisitions.As uninformed investors bought more,prices rose further.Eventually price increases stopped,conglomerates failed to perform up to uninformed investors'expecta- tions,and stock prices collapsed.Although in the end disinvestment and perhaps short sales by smart money brought the prices of conglomerate stocks down to fundamentals,the initial buying by smart money,by raising the expectations of uninformed investors about future returns,may have amplified the total move of prices away from fundamentals.Soros'analysis of REITs tells the same story. Soros'view of self-feeding bubbles has a distinguished history,dating back at least to Bagehot (1872).According to Bagehot,"owners of savings...rush into anything that promises speciously,and when they find that these specious investments can be disposed of at a high profit,they rush into them more and more.The first taste is for high interest [i.e.,large fundamental returns],but that taste soon becomes secondary.There is a second appetite for large gains to be made by selling the principal which is to yield the interest.So long as such sales can be effected the mania continues...."Kindleberger (1978)also sees For similar accounts,see Tobias(1971),Goodman (1972),and Graham(1974). Copyright 2001 All-Rights Reserved
Positive Feedback Investment Strategies 381 speculative price movements as involving "insiders [who]destabilize by driving the price up and up,selling out at the top to the outsiders who buy at the top and sell out at the bottom....[T]he professional insiders initially destabilize by exaggerating the upswings and the falls,while the outsider amateurs who buy high and sell low are...the victims of euphoria,which infects them late in the day.” In addition to its historical distinction,the view that the interaction of informed rational speculators and positive feedback traders leads to price destabilization has several plausible empirical implications.Our model generates a positive correlation of stock returns at short horizons,as positive feedback traders respond to past price increases by flowing into the market,and negative correlations of stock returns at long horizons,as prices eventually return to fundamentals.This feature of realized returns has found some empirical support in recent studies of stock prices (Fama and French,1988;Poterba and Summers,1988;Lo and MacKinlay,1988).Our model also predicts that the stock market overreacts to news because such news triggers positive feedback trading.Campbell and Kyle (1988)estimate a model in which innovations to news and to noise are highly positively correlated in U.S.stock prices. Our paper follows a significant literature addressing the question of destabil- izing speculation.Respondents to Friedman(1953)have previously stressed that, in the presence of rule of thumb investors,it might pay a large speculator to destabilize prices (for example,Baumol,1957;Telser,1959;Kemp,1963;Farrell, 1966;and Hart,1977).Although our work is related,we focus on small competitive rational speculators who cannot individually affect prices.Hart and Kreps(1986) construct a model in which competitive rational speculators are the only investors able to perform physical storage.Their activity can change commodity supplies in a way that makes equilibrium prices more volatile.It is difficult to compare our results to those of Hart and Kreps (1986)because in their model price- destabilizing speculation results from the effect of storage on quantities,while in our model quantities are fixed,but equilibrium prices are still less stable in the presence of rational speculators.Stein(1987)observed that imperfectly informed rational speculators introduce noise as well as information into asset prices and can make prices carry less information about the state of the economy and be less stable.Stein's ingenious idea is perhaps more applicable to dramatic events like the October 1987 market crash,when much uncertainty surrounds the value of fundamentals,than to speculative (but probably not fully rational)bubbles like the conglomerate boom. This paper is organized as follows.Section I describes some evidence suggesting that positive feedback portfolio strategies are common.Section II presents a simple model that combines speculators'trading in anticipation of noise demand with positive feedback strategies to show that the addition of rational speculators can destabilize prices.Section III concludes. I.Positive Feedback Trading A wide variety of trading strategies call for buying stocks when their prices rise and selling stocks when their prices fall.These strategies include portfolio choice Copyright O 2001 All Rights Reserved
382 The Journal of Finance based on extrapolative expectations,the use of stop-loss orders,purchases on margin which are liquidated when the stock drops below a certain point,as well as dynamic trading strategies such as portfolio insurance.Below we summarize some of the experimental and survey evidence suggesting that positive feedback trading,especially of the extrapolative expectations variety,is common. The most telling experimental evidence on the tendency of investors to chase the price trend comes from the work of Andreassen and Kraus (1988).2 In their experiments,Andreassen and Kraus show subjects with some training in econom- ics authentic stock price patterns,tell them that these stock prices are authentic, and ask them to trade at given prices.Subjects begin with some endowment and with knowledge of a current stock price and are then asked to alter their positions with every new observation of the stock price,without having an effect on this price. Andreassen and Kraus's results are striking.When over some period of obser- vations the level of the stock price does not change very much relative to the period-to-period variability,subjects track this average price level:they sell when prices rise and buy when prices fall.If,however,over a period prices exhibit a trend relative to the period-to-period variability,subjects begin to chase the trend,buying more when prices rise and selling when prices fall.3 Instead of extrapolating price levels to arrive at a forecast of future prices,subjects switch to extrapolating price changes.This switch to chasing the trend appears to be a virtually universal phenomenon among the subjects that Andreassen and Kraus study.Interestingly,the switch to trend chasing seems to occur only in response to significant changes in the price level over a substantial number of observations, not in response to the most recent price changes alone. In addition to experimental evidence,significant survey evidence points to the prevalence of extrapolative expectations.Case and Shiller(1988)find that home buyers in cities where house prices have risen rapidly in the past anticipate much greater future price appreciation than home buyers in cities where prices have been stagnant or have fallen.Shiller(1988)surveys investors in the wake of the 1987 market crash and finds that most sellers in the market cite price declines as the reason that they have sold-presumably because they anticipate further price declines. Perhaps the most interesting survey evidence on extrapolative expectations is presented in Frankel and Froot's(1988)work on the dollar exchange rate in the 1980's.Frankel and Froot evaluate the forecast and recommendations of a number of exchange rate forecasting services during the period in the mid-1980's when the dollar had been rising for some time without a widening in U.S.-rest of world interest rate differentials and with a rising U.S.trade deficit.During this period, Frankel and Froot find that the typical forecaster expected the dollar to continue to appreciate over the next month but also to depreciate within a year in accordance with underlying fundamentals.Consistent with these expectations, 2 The evidence from market experiments reported in Smith,Suchanek,and Williams (1988)is consistent with trend-chasing by experimental subjects. Andreassen and Kraus'trending series increased or decreased by nine percent over forty simulated trading days.Their trendless series were adjusted so that the last price quoted in a forty simulated trading day interval was equal to the first price. Copyriaht 2001 All Riahts Reserved
Positive Feedback Investment Strategies 383 forecasting services were issuing buy recommendations while maintaining that the dollar was overpriced relative to its fundamental value.Such trend-chasing short-run expectations,combined with a belief in a long-run return to fundamen- tals,are hard (though not impossible)to reconcile with a fully rational model. Extrapolative expectations resulting from biases in judgment under uncertainty are probably the most common form of positive feedback trading,but they are by no means the only form.For example,such strategies can be rational if preferences exhibit risk aversion that declines rapidly with wealth(Black,1988; Leland and Rubinstein,1988).In our framework,however,usual portfolio insurance strategies are not rational,since stock prices do not follow random walks and positive feedback traders get clobbered in the market.We therefore must assume that positive feedback traders are simply noise traders who buy according to a fixed demand curve when prices rise and sell when prices fall. An important objection to this approach is that such positive feedback traders are really dumb:they do not realize how much money they lose by chasing the trend.Why don't positive feedback traders either learn that they are making mistakes or else lose all their wealth and disappear from the market?We do not find this objection fully compelling.First,every episode might look different to positive feedback traders,and so their learning from past mistakes might be limited.Learning might be especially limited if each episode of divergence of prices from fundamentals takes several years,as might have been the case with conglomerates and real estate investment trusts.By the time the new bubble comes along,many investors have forgotten the old one or have been replaced by younger investors who have never experienced the old one at all.Second,even when noise traders take a bath they may save and return to the market later, especially if several years pass between bubbles.Finally,as we showed in earlier work,if traders'mistakes cause them to take positions that carry more market risk than rational investors'positions,they can earn higher returns in the market even if they make judgment errors.Although we do not model this effect here,in principle it can be a significant deterrent to learning.For these three reasons, positive feedback trading may well persist in the long run. Importantly,instances of positive feedback occur at many horizons.Investment pools whose organizers buy stock,spread rumors,and then sell the stock slowly as positive feedback demand picks up rely on extrapolative expectations over a horizon of a few days.Frankel and Froot's forecasters have a horizon of several months,which also appears relevant for bubbles like those that may have occurred in 1929 and 1987.The conglomerate boom,by contrast,lasted several years What distinguishes these examples is the historical frame over which extrapola- tive expectations are formed.In some cases people react to a price rise over a few days.In other instances much longer records of high realized returns are used. As long as people expect a price rise over the particular horizon on which they focus to continue,they form extrapolative expectations that may support positive feedback trading patterns.For this reason,we think that our model applies to a variety of horizons.However,the learning argument suggests that the application +As we discuss below,however,positive feedback behavior would not result from dynamic hedging strategies by rational investors in our model. Copyright 2001 All Riahts Reserved