By Jason Zweig | June 16, 2017 5:31 pm ET
Image credit: J.S. Pughe, “A Dangerous Bubble,” from Puck, Oct. 22, 1902, Library of Congress
To get out of a bubble before it bursts, you have to be extremely smart, extremely lucky — or both.
That’s the principle that Samuel Lee, the subject of my column today, is testing. He has bought into Ethereum, the hot cryptocurrency. Mr. Lee is convinced that it is a bubble, all but certain that it will burst and fairly sure he will lose most of his money. But, if Ethereum works out, he believes he could make even more than the roughly 1,500% gain he has already achieved on paper (or, should I say, in ether).
The problem with participating in bubbles, of course, is that once they inflate further, your gains make it harder and harder to let go. The more you make, the more you want to make and the more you hate to cash out the asset that is making you rich.
Often, an expanding bubble exerts a kind of magnetic field that seems to disable rational thought.
A study released in 2006 surveyed 845 people who got burned on technology stocks when the internet bubble burst in 2000. Fifty-four percent said they had bought a stock they believed was already overvalued because they thought it would go even higher. Nearly half said they were convinced that tech stocks were in a bubble. Most of them ended up losing their shirts by waiting too long to sell.
Similarly, a Gallup poll in February 2000 found that 48% of investors thought the stock market was in a bubble (which it was!), with only 3% saying they thought it was cheap. Yet, on average, investors expected stocks to gain 15.2% over the coming 12 months. (In fact, the S&P 500 fell 8.2% over that period.)
Or consider this advertisement,
which ran in the Saturday Evening Post on Sept. 14, 1929.
The Standard Statistics Co., predecessor of today’s Standard & Poor’s, mocked the stock-market bubble of 1719-20, “when all Europe guessed wrong” and speculators faced “utter ruin.” In 1929, however, “you need not guess,” said the ad. “Today, it is inexcusable to buy a ‘bubble,’” since every investor could now afford to obtain “the facts.”
If only that had been true!
The stock market in September 1929 was valued at more than 32 times its average long-term earnings, adjusted for inflation. That was then its highest level ever recorded, according to data compiled by Yale economist and Nobel laureate Robert Shiller.
Six weeks after the Standard Statistics ad ran, the stock market fell 12% in a day, and the Great Crash of 1929 was underway. Today, many financial historians regard 1929 as one of the worst bubbles on record.
Still, spotting bubbles isn’t nearly as easy as it sounds. In recent years, various market commentators have proclaimed a bubble in bonds, stocks, gold, venture capital, private equity, financial-technology companies, market-tracking index funds and who knows what else.
I once asked Robert Shiller, who presciently warned investors that both the internet and real-estate bubbles would burst, if it’s possible to call a market top or even to distinguish a bubble from a bull market with certainty. “Being right about past bubbles does not automatically ensure that you will be right about the next,” he told me in 2011.
Even Charles Mackay, the astute journalist and historian who wrote the influential book Extraordinary Popular Delusions and the Madness of Crowds in 1841, got swept up in a bubble.
After intensively studying and then mocking the people who had bought tulip bulbs in Holland in 1637 and stock in the South Sea Co. in 1720, the most influential critic of bubbles who ever lived fell hard for a bubble right under his nose. Mackay ended up praising the boom in British railway shares of the mid-1840s — in which many investors ended up getting wiped out. He may well have been among them.
In short, when you mess around with a bubble you can end up messing up your own mind.
Source: WSJ.com, MoneyBeat blog, http://on.wsj.com/2sk4g0W
For further reading:
Definitions of BUBBLE, HERDING, IRRATIONAL, FINANCIAL ADVISOR, INVEST, SMART MONEY, SOPHISTICATED INVESTOR, and SPECULATE in The Devil’s Financial Dictionary
Chapter One, “Investment versus Speculation,” in The Intelligent Investor
Chapters Three and Four, “Greed” and “Prediction,” in Your Money and Your Brain
William N. Goetzmann, “Bubble Investing: Learning from History,” Chapter Nine in Financial Market History (CFA Research Institute)
Carmen Reinhart and Kenneth Rogoff, “Causes of Financial Crises Past and Present: The Role of the ‘This Time Is Different’ Syndrome”
Robert Shiller, Irrational Exuberance
Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds
Edward Chancellor, Devil Take the Hindmost: A History of Financial Speculation
Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises
Eugene N. White (ed.), Crashes and Panics: The Lessons from History
What’s Speculating? What’s Investing? Some of the Wisest Investors Weigh In