Saturday, September 3, 2011

Investment Bubbles, Manias, and Panics. Remain Patient and Rational when Investing. Tulip Mania, The South Sea Company, the Great Crash.

According to most, an investment bubble could be described as a period of high trading volumes at prices that are at odds or at a high variance above common measures of intrinsic value. For housing, the intrinsic value of the property might be a multiple of its net rental income, for a common stock, a multiple of its book value, earnings, or dividend payments.

During the "dot-com" or technology bubble stock prices for most technology and telecommunication companies were trading well above any reasonable measure of current earnings or dividends. To be sure, a vast number of the companies involved in the tech bubble had little to no earnings at all. Former Federal Reserve Chairman Alan Greenspan coined the phrase "irrational exuberance" to describe the psychology of investors and markets during this time. Many people believed that prices would go up forever because modern technology would transform business and enable them to achieve future earnings that seemed unfathomable only a decade before. So goes the usual mantra at least. More sensible minds, however, would conclude that vast amounts of people, acting of their own volition, chose to casually disregard all semblance of reason with regards to corporate fundamentals and instead act on faith... a faith that other people would be dumb enough to keep buying securities of dubious intrinsic or real value and thus provide someone to whom they could sell their shares at a higher price in the future.

Acts of faith, however, are better left to theological or religious spheres than investment ones. Crowds are prone to turn and panic with little warning and little chance for the average investor to escape. When an investment bubble bursts, unless you got in near the point of its initial ascent, you will most likely be waiting years to recover your losses and return to break-even. And in other instances, your break even point may be unattainable as your investment dropped to zero.... a 1,000,000 % gain on zero is still zero.

There have been numerous investment bubbles and manias over the centuries. Tulip Mania first hit Holland and then began to burst circa 1637. During this time, a single tulip bulb could fetch the price of a home or 10x the annual earnings of a skilled craftsman. Rational? Of course not, but investors were hoping that another sucker would come along and buy their tulip bulbs for a little higher in a week, month, or year down the road. They wanted to ride the upsurge in tulip bulb prices and make it rich quick.

There was also the South Sea Company and Mississippi Company Bubbles of the 1720s, the Railway Manias of the 1840s, the Great Crash of 1929, and countless others on markets all around the world. What propels bubbles? Behavioural psychologists could undoubtedly write books on people's particular motivations, but stupidity and greed mark the top of my list. If something does not make money, don't buy it. If it would take over 25 years to make your money back given present earnings levels, move on to another investment. There is no need to succumb to get rich quick schemes when honest rational investments are in plentiful supply. Rationality and patience will always win the day in the investment business, it just might take some time, and a fair amount of resistance to greed.

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