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Market bubbles

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As children, we were taught that what goes up must come down. As adults, we often ignore this sage advice when it comes to investing and money matters. Like the good times, a rising market can’t last forever. All trends end, making price corrections (declines) inevitable.

While no one likes to lose money, corrections are commonplace. They are part of the investment landscape and allow a market to pullback on overpriced valuations. Savvy investors welcome a dip in the market and use it as a hunting ground to seek out assets at prices that are not inflated.

By taking the heat out of a market, corrections help ensure that asset prices do not get out of sync with their intrinsic value. Price slumps also help ward off speculative bubbles. History shows that when the price of an asset skyrockets to unsustainable levels, a harsh correction (crash) may be on the way.

Spectacular gains have a habit of turning into devastating bubbles whenever investor enthusiasm for an asset class reaches fever pitch. Irrational exuberance among investors propels a surge in the price to a lofty height which is unwarranted by the fundamentals of the asset.

A common element that runs through most bubbles is the lapse of judgment by individuals whose illogical behaviour becomes contagious. Other investors blindly follow the crowd as the market races higher and are led astray in making the same poor investment choice.

This herd mentality (madness of the crowd) helps explain why speculative surges in asset prices develop. Rising prices attract the attention of a wider audience who see others getting rich - and they want a piece of the action! As explained by Investopedia, an asset bubble - like a snowball - feeds on itself.

When an asset price begins rising at a rate appreciably higher than the broader market, opportunistic investors and speculators jump in and bid the price up even more. This leads to further speculation and further price increases not supported by market fundamentals. The real trouble starts when the asset bubble picks up so much speed that everyday people, many of whom have little-to-no investing experience, take notice and decide they can profit from rising prices. The resulting flood of investment dollars into the asset pushes the price up to even more inflated and unsustainable levels.

Investor mob psychology is evident in all bubbles and each provides a cautionary tale about getting caught up in financial hysteria. When one person’s flawed judgment influences another person’s investment decision, errors compound and a bubble forms.

The first recorded capitalist speculative bubble occurred in the 1630s in Holland. Known as the Dutch tulip bulb mania, it saw working class folk buy flower bulbs for extraordinary sums of money until, without warning, the market for them dramatically collapsed.

Frenzied buying reportedly resulted in one particular bulb selling for as much as a mansion in a fashionable Amsterdam neighbourhood. The rare and exquisite bulbs had become status symbols and people clamored to get their hands on one. Prices reached the point of lunacy and the bubble ultimately burst.

Less than a century after the tulip craze, overzealous investors watched their life savings vanish when the South Sea Company collapsed in 1720. Yet again, people flocked to an irrationally exuberant market after speculation mania about “Britain’s hottest stock” swept throughout the nation.

The South Sea Company was granted a monopoly on trade in the South Seas in exchange for assuming England’s war debt. The company’s executives exaggerated the commercial value of its trading rights causing its shares to soar, thereby fanning enormous interest in the stock.

One notable investor swayed by the hype was Sir Isaac Newton. The scientific genius who invented calculus and formulated the laws of gravity, lost most of his fortune on a stock that briefly defied gravity. He reportedly stated: “I can calculate the motions of stars, but not the madness of men”.

Between Newton’s loss and now, there have been numerous market crashes. Most readers will recall the dotcom bubble that formed in the late 1990s. Investors became overly optimistic about technology companies and inflated their values. Excitement over the new Internet economy clearly got out of hand.

And who can forget the financial calamity that was the Global Financial Crisis. A US housing collapse triggered the worst economic crisis since the Great Depression. Herd mentality was again at work with home buyers influenced by the purchasing behaviour of others. Americans outbid their neighbours in a desperate rush to get onto the fast-rising housing ladder.

When it comes to investing, history shows that humans are hard-wired to stampede with the crowd and the latest example of this is Bitcoin-mania. The cryptocurrency’s meteoric rise displays all the signs of a textbook bubble - naïve investors with misplaced confidence placing huge bets on something they truly don’t understand because everyone else is taking a punt on a new digital asset.

In mid-December, the value of a single Bitcoin rocketed to a staggering US$20,000 driven by self-reinforcing price gains. This was nosebleed territory and a giant throw of the dice for gullible investors who had been lining up to pour money into the latest craze. (Bitcoin dramatically dropped below US$13,000 in the immediate run-up to Christmas.) Most Bitcoin buyers are millennials and they clearly have a different risk appetite to baby boomers.

Many commentators and central bankers are understandably raising a red flag, believing that Bitcoin will end in tears for many. It is now the biggest bubble in history and only time will reveal how long this wild ride will last. When the crest is reached and the bubble pops, the downward roller coaster ride will leave a trail of misery.

As Newton discovered, markets can’t defy gravity forever. Yet each generation believes that “this time will be different” and that upward trends never end. It’s clear that when it comes to investing, humans are predictably irrational, thereby making periodic bouts of chaos inevitable. Which just proves the adage that those who fail to learn from history are doomed to repeat it!

Paul J. Thomas, CEO


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CEO Paul Thomas