“At some point in the growth of a boom, all aspects of real estate become irrelevant except the prospect of an early rise in price.” — John Kenneth Galbraith
Countless asset bubbles have inflated and burst throughout history and it is an absolute certainty that more will come. The bubbles repeat so often because hundreds of thousands of years of evolution have integrated the herd instinct into the human brain. Despite the repetition, each bubble feels unique in its own distorted way. But after studying dozens of them, I found that investors can protect themselves by recognizing the path that most are following. The crypto mania of the 2010s and 2020s is just the latest example, and as far as bubbles go, it fits the pattern pretty well.
Stages in the life of a bubble
1. A new innovation emerges with potential mass-market applications
Tulip manias notwithstanding, most asset bubbles tend to form around some promising new technology that can radically transform society. Think: canals, railways, consumer electronics, and e-commerce. The allure of the mass market is what makes asset bubbles hard to spot at the moment. They can only happen when many believe they are not happening, ensuring that skeptical concerns are drowned out by the noise of the crowd.
The circular logic of cryptocurrency advocates holds that cryptocurrencies represent the foundation of a new, unregulated, decentralized financial system that will render traditional central banking and fiat currencies obsolete. They forget that central banks were specifically designed to mitigate the very dangers of an unregulated, decentralized financial system.
2. Early investors get windfalls
First movers have a clear advantage and often generate gigantic returns. But your good fortune tends to be due more to luck than skill. They were simply the first to arrive at the buffet. However, as Louis D. Brandeis observed, “The weakness of human nature prevents men from being good judges of their own merits.” Early investors brag about their achievements and attribute their success to their investing acumen. Emboldened by media adulation, they encourage new investors to join the stampede, further increasing their wealth. The self-reinforcing advertising cycle intensifies and the lucky pioneers, the Sam Bankman-Frieds, are heralded as the market gurus of a new age.
3. Late adopters inflate the bubble.
Fueled by the reckless evangelism of these newly minted gurus, the fear of missing out (FOMO) drives many more to join the frenzy. The flood of new capital inflates prices even beyond the most optimistic metrics of fundamental value. Battle-tested investment principles are discarded and replaced with new ones developed to rationalize the madness: dot-coms no longer need to make a profit, they just need to acquire users; Cryptocurrency exchanges no longer need the protections of a well-regulated banking system that was designed to prevent the very abuses they engage in.
4. The money supply is reduced.
The mania may eventually reach a point where inflated asset values and tight working conditions fuel inflation. Central banks react by tightening monetary policies and reducing the money available to push prices up further. Crypto investors are now experiencing this pressure.
Without central bank intervention, the mania could persist until the money simply dries up on its own. So when the crack hits, there is nothing to stop or mitigate the deflationary death spiral. Stories of the so-called “hard times” in the mid-19th century testify to the misery of such an experience.
5. Panic and Shock
As the reserve of new capital is depleted, sellers begin to outnumber buyers. Before long, investors conclude that innovation may not change the world or be as valuable as they thought. The pain of falling asset prices soon turns to terror at the possibility of a total loss of capital. The asset price plummets. As a result, bankrupt investors discover that many bubble evangelists and companies were wildly optimistic at best and clueless con artists or outright frauds at worst.
6. Forget and repeat
Punished investors agree not to make the same mistake again. But as John Kenneth Galbraith pointed out, “For practical purposes, it must be assumed that the financial memory has a maximum duration of no more than 20 years.Indeed, a decade or two from now, few investors keep their promise. Michael Saylor exemplifies this principle: he was caught up in both the dotcom and cryptocurrency bubbles, which were 21 years apart.
Protection against the next bubble
So how can we resist the updraft of the next asset bubble? It won’t be easy, but sticking to some principles can help.
1. Resist the temptation to cheat time
The best investors in history: the hetty greens and Warren Buffetts, show extraordinary patience. They understand that successful investing is more like watching paint dry than hitting the jackpot on a slot machine. Victims of the asset bubble often suffer from the desire to squeeze the time it takes to turn a little money into a lot. But there are more dead ends in investing than there are shortcuts. Remembering this principle will help us see bubbles for what they are and avoid turning too much money into too little.
2. Prepare to be alone
Bubbles expand only when a sizable part of the market believes that the frenzy is justified. This, in turn, drives FOMO. The rare voice of reason is rarely heard. In the run up to the Great Depression, Charles E. Merrill, founder of Merrill Lynch, warned that stock prices had reached absurd levels. He was right, but the market rallied for more than a year before the crash came in October 1929. Meanwhile, he was relentlessly taunted and came to question his own sanity before seeking psychiatric treatment.
The principle to remember is that those who acknowledge asset bubbles will find that few people agree with their assessment. Perhaps the only consolation is the close correlation between the depth of an opponent’s loneliness and the money supply available to feed an asset bubble. When there is no one left to feed the bubble, collapse is imminent. So the more alone an opponent feels, the closer the bubble is to deflating.
3. Seek the wisdom of skeptical and successful investors
We don’t have to fall into asset bubbles. Some investors have repeatedly avoided them and have a long and successful track record in the markets. Two of the most prominent examples today are Buffett and Charlie Munger. Neither indulged in the go-go stocks of the 1960s, the dot-com bubble of the 1990s, or the crypto craze of the 2010s and 2020s. Maybe they missed a few opportunities along the way, but that hardly makes up for his accomplishments. As a precocious Ray Dalio’s Bridgewater employee once said, “When you ask someone if something is true and they tell you it’s not entirely true, it’s probably true in general.” A corollary principle applies here. So when Buffett warns that cryptomania is a hoax that attracts charlatans o Munger describes madness as “an investment in nothing,“we must listen.
4. Study financial history like it’s your job
Almost every financial event, and certainly every asset bubble, has at least one compelling historical parallel. Investors who follow the lessons of financial history rather than the constant noise of financial news will discover that the present is not as mysterious as most people think. Investors who live in the moment may not detect the start of the next bubble, but those who have studied dozens of previous bubbles are more likely to recognize the red flags. Therefore, we should study financial history as if our wealth depended on it, because there is a good chance that one day it will.
Asset bubbles are a feature of financial markets that will never go away. They are hard to spot and hard to resist. But hopefully some of these lessons will help us refrain from participating in the next one.
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All messages are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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