There is this famous story of Joseph “Joe” Kennedy (JFK‘s father) exiting the stock market right before the 1929 crash when his shoeshine boy started giving him stock tips. He figured that if a shoeshine boy is giving him a rundown on what stocks to buy or sell, the market has become too popular for its own good. That during a time when regular folks did not invest in the stock market right until that euphoric peak, as always. And the rest as they say is history.
And it is not the participation of regular folks in the stock markets that is the problem. It is participation in an on and off, herd-like pattern that cause these bubbles and the eventual bust.
Bubbles happen because we are a jealous, envy-laden bunch. We see our neighbor make a killing on some stupidly dumb investment and we say, why not me. It is ingrained in our nature which then causes prices of even reasonable assets to detach themselves from their fundamentals from time to time.
Nothing so undermines your financial judgement as the sight of your neighbor getting rich.
J. P. Morgan
People start being interested in something because it’s going up, not because they understand it or anything else. But the guy next door, who they know is dumber than they are, is getting rich and they aren’t. And their spouse is saying can’t you figure it out too? It is so contagious. So that’s a permanent part of the system.
Warren Buffett
So, asset bubbles are inevitable. But how do we know if we are about to partake in one? William Bernstein, neurologist turned investment advisor and a writer par excellence, lists these four signs:
- Popularity – You go to a party and everyone is talking about the killing they are making on tech stocks or the real estate they are flipping. Or your cab driver is talking about bitcoin or ethereum, that’s a bubble.
- Job quits – When people quit their stable professions to day trade or speculate or flip houses full time, that’s a bubble.
- Skepticism met with anger – You express skepticism on investing in something that’s been popular lately and you’re not just met with disagreement but with anger, that’s another sign. We saw a bit of that with the crypto and NFT bros talking down anyone who questioned their investment thesis because who does not like to get effortlessly rich doing nothing.
- Extreme predictions – The last feature of a potential bubble is extreme predictions. Bitcoin is not just going to go to 100,000 dollars but is going to go to a million. When you see those sorts of extreme predictions, you can be sure that you are in a bubble.
The unfortunate problem with bubbles is that they can go on for a very long time before they burst. Alan Greenspan, the then Federal Reserve chairman, in a December 5th, 1996 speech he gave at the American Enterprise Institute, warned investors that stock market valuations, especially for the tech-heavy Nasdaq, were nutty. Yet, Nasdaq went on to quadruple from that point on before the bubble burst in March of 2000.
So even knowing that there is a bubble did not help. What do you do then? A few takes still:
- A simple yet a solid financial plan built around the basics of investment finance would make certain that you won’t go plunking down your hard-earned dollars on any crazy idea that comes along.
- FOMO is a bit*h. Free lunches in investing are few and far between. Be wary of hot tips and realize that you’ll never see the full picture of other people’s investments, especially of the “experts” that you hear or see in the media.
- Expected returns from any investment should make sense. I use the yield on 10-year Treasury bonds, the safest of all investments around, as a benchmark. And 10-year roughly matches the duration for any long-term investment so if that bond yields 4 percent and if something else yields 5, there is risk. Quantify that risk and invest accordingly.
- An investment today means cash flows now or in the future. Steering clear of any investment that does not produce cash flows or has ever a prospect of producing cash flows would help you avoid a lot of heartburn. You don’t have to have Aswath Damodaran level of valuation expertise but knowing some basics on business valuations will take you far in sidestepping a lot of the mess.
- And last, knowing a bit about historical stock and bond market returns will only help. It’ll provide you the context you’ll need around what you should reasonably expect from a diversified portfolio of investments. Any deviation from that means you are taking on uncompensated risk. Nothing wrong with that as long as you know what you are getting into. And limiting that to a tiny portion of your money will make sure that a blowup will not upend your life.
Thank you for your time.
Cover image credit – Andrea Piacquadio, Pexels