DP4221 Riding the South Sea Bubble
The efficient markets hypothesis implies that, in the presence of rational investors, bubbles cannot develop. We analyse the trading behaviour of a sophisticated investor, a London goldsmith bank, during the South Sea bubble in 1720. The bank believed the stock to be overvalued, yet found it profitable not to attack the bubble. Detailed examination of daily transactions in the London stock market shows that ?riding the bubble? was a highly profitable strategy. These findings lend support to recent theoretical work arguing that predictable investor sentiment may prevent rational investors from attacking a bubble.