How to Spot Bubbles

‘Never underestimate the power of stupid people in large groups.’ George Carlin.

Whatever your goals, it’s sensible to avoid actions that reduce your chances of success. If you’re working on fitness, don’t eat a box of doughnuts. If you’re sketching, don’t use a blunt pencil.

The equivalent for your finances is getting caught up in a bubble. It will drive you mad, poor or both. To avoid this trap, we need to better understand what bubbles are, why they form, and what gives them momentum.

Bubbles

A bubble occurs when the price of an asset rises far above its value. This has happened many times throughout history. Some of the most famous examples are Dutch Tulip Mania in the 1630s (where people sold houses to buy tulips), the South Sea Bubble in 1720 (which even fooled Isaac Newton), the US stock market bubble in the 1920s, the internet bubble in the 1990s, the US housing market bubble in the early 2000s, and the crypto bubble of recent years. Needless to say, bubbles happen again and again.

These periods of irrational exuberance follow similar patterns each time – even if the underlying asset is different. They all involve herd mentality and the worst human trait – self-delusion.

Early in a bubble, asset prices rise, as it seems the asset has some value. The increase in price (not increase in value) drives more investors to buy, sending the price even higher. At some point, there is a wobble, where initial buyers cash out. Prices decline slightly, but the wobble is only temporary, because the later buyers, who have seen some gains, see a slight sell-off as a good opportunity to buy more. They are fully swept up in the mania.

Meanwhile, new prospective investors see that this asset – which at first they doubted – has weathered a slight sell-off, and recovered in price. This price movement gives them a false sense that everything will be fine, encouraging them to buy in too. These buyers go to colleagues, friends and family, telling them how much money they’ve made and why this investment is a no-brainer.

Eventually those who were sceptical or told themselves they would never buy, also become buyers – because they see their friends making money and feel the fear of missing out. This pushes the price higher still. At some point, your grandparents (or in my case my barbers!) start telling you about their crypto wins. It’s peak madness!

But after a while, the market hype, euphoria and greed all run out, and those who bought earlier become spooked that their speculative asset is, in fact, too good to be true. And so they begin to sell. Whereas earlier a falling price was a chance for the speculator to buy, now everyone who was going to buy has already bought, so there is no-one left to push up prices again. As such, prices continue to fall, driving more concern among speculators, and causing them to capitulate, selling yet further.

Typically, there is so much despair that prices go from far above intrinsic value to far below, before recovering to around fair value.

This whole process relies on the greater fool theory.

The Greater Fool

If you were to buy an asset today, and be forced to hold it for ten years, would you still buy it? That’s a good test for whether you believe in its fundamental value.

The greater fool theory suggests that most people don’t do this, and this explains much of why bubbles are formed.

The theory – as the name suggests – proposes that you may know you’re a fool for buying an asset at price X, but you believe there will be a greater fool down the line who will buy the same asset at price X +50%. The bubble continues for as long as there are greater fools than you, but at some point the price will be so high, that there are no more fools willing to buy. As such, the price falls, and falls fast, and you lose money far more quickly than you made it in the first place.

This is the root of all speculative mania – the view that the value of your asset is how much someone else might be willing to pay for it, regardless of its actual value.

Investment vs Speculation

At the heart of all bubbles is the difference between investors and speculators.

Investors buy an asset because that asset generates cash flows in the years to come, which the investor feels are worth enough to warrant the price paid today. This is investing based on the value of the asset.

Speculators, however, buy an asset because they think that the price of the asset will rise in the future. They are speculating based on the price.

The investor builds his castle on the rocks – he makes an estimate of future cash flows (e.g., earnings, dividends) that the asset will produce, and works out his fair value accordingly. If he can find an asset for less than its fair value, he’ll buy it. If he holds an asset where price is above fair value, he’ll sell it.

But the speculator builds his castle on the sand. He is buying and selling based on price. He has no idea of value, and is probably buying above fair value as a result. His strategy is one of hope – he hopes that there will be someone else out there willing to pay more for the asset in the future. Sooner or later we all realise – hope is not a strategy.

So how best to avoid these bubbles? Ask yourself the following questions:

• Do I understand the fundamental value of the asset? This means you need a number for what you think is a fair price. If not, don’t buy.

• How did I hear about this asset? Is it from other people who are caught up in greater fool theory? If so, don’t buy.

• If I couldn’t sell this asset for ten years, would I be happy to buy it today and hold it for a decade? If not, don’t buy.

• Are non-investors buying the asset? If so, avoid it, because speculation is probably pushing up the price. And speculation will lead to a crash in the asset price down the line.

• Do people justify higher asset prices by saying ‘This time is different’? If so, run!

Imagine you went to a clothes shop and bought a t-shirt for £10. You thought it was worth £10, so you were happy to buy at that price. The next week, the t-shirt went up in price to £15. The following week it rose to £20 and everyone started talking about the t-shirt as the next best thing. The next month it rose to £30. It’s still a t-shirt. You wouldn’t go and buy more t-shirts at £30, just because everyone else was buying at that price. If you were smart, you might even sell the one you bought for £10 to someone who wants to buy at £30.

In the same way, it’s mad to be swept up in a wave of hype, overpaying for an asset, and losing out when prices inevitably fall. It’s a waste of money, and unnecessary stress. You’re more likely to win by going to the casino and betting on black. Avoid the bubbles and think long-term.