Research Affiliates: The China Syndrome: Lessons From The A-Shares Bubble

September 21, 2015

Winners And Losers

For every transaction there is a buyer and a seller. As the A-shares market rose, trading volume also stepped up meaningfully. Investors might have recognized the rapidly expanding amount of margin debt in the system as a sign of rampant speculation and prudently reduced their positions. No doubt, many sophisticated investors—local hedge fund managers and traders at large financial institutions—took profits as the market became more expensive and increasingly speculative. It is also common knowledge that company insiders aggressively issued new shares and unloaded their personal stakes to take advantage of what they perceived to be irrationally high prices for their stock.

Many of the buyers opposite these profit-taking sellers were naïve investors who did not properly evaluate company fundamentals or assess the investment risk of buying equity shares at three-digit P/E's. Is it a failure of the stock market when investors who choose not to properly assess company fundamentals and investment risks are penalized or even eliminated from participation?

Quite the contrary, a well-functioning market should chasten those who compete poorly and reward those who compete well. However, the brutal efficiency of transferring wealth from retail investors into the pockets of hedge funds and iBank proprietary desks is inconsistent with the values of many policymakers who favor economic equality. It bears mention that bubbles can also catch hedge funds, proprietary trading desks, and insiders unawares, too; it's not just the little guy who gets crushed by the aftermath of a bubble. Nonetheless, I suggest that the Chinese bubble is not primarily an economic crisis. It is better understood as a social crisis occasioned by a massive wealth redistribution that disfavors average investors.

There are always winners and losers in the stock market. Can we truly feel sorry for the losers, even if they are retail investors who can ill afford losses? After all, people enter the market voluntarily. What damage do we do if we seek to over-protect adults who make mistakes? As an old Chinese saying goes, "You lay down the bet, you live with the consequences."

Yet there are valid reasons to be concerned about retail participation in the equity market. Naïve speculation in the stock market has features in common with smoking and pathological gambling. Smokers face horrible illness and early death; compulsive gamblers face ruination. Similarly, stock trading leaves most retail investors worse off than they would be if they simply held index funds (Barber and Odean, 2000). Moreover, smoking and addictive gambling have negative externalities. Smoking produces harmful second-hand smoke and contributes heavily to the cost of health care, while pathological gambling breaks families apart and fosters crime. Likewise, naïve speculators' active trading has negative externalities: By adding noise to the price discovery process, it can actually decrease market efficiency, and damage the real economy in the process.

Most societies try to discourage people from smoking at all and gambling too much. I think there are strong reasons for policymakers, investment industry associations, and finance educators to dissuade individuals from engaging in uninformed speculation. The issue isn't just that retail investors tend to be long-term losers in the stock market. They also hurt the quality of the market and thus injure the real economy over time.


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