JFK‘s father, Joseph “Joe” Kennedy, exited the stock market right before the 1929 crash when he heard his shoeshine boy give stock advice. He figured that if a shoeshine boy is giving him a rundown on what stocks to buy, the market has become too popular for its own good. That was during a time when most did not invest in the stock market but at that euphoric peak, everyone wanted in. And the rest as they say is history.
And it is not partaking in the stock market that is the problem. It is partaking in extreme speculation in a herd-like manner which becomes a problem. It causes bubbles and the follow on bust causes a lot of grief and pain.
Bubbles occur because we are a jealous, envy-laden bunch. We see our neighbor get rich on some dumb investment and we say, why not me? It is ingrained in us, so we chase the same investments which then causes their prices to detach themselves from reality until they eventually crash back to earth.
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
Bubbles hence are inevitable. But how do we know if we are 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 talks about the killing they are making in tech stocks or in flipping real estate. Your Uber driver talks bitcoin and Ethereum, those are signs of a bubble.
- Job quits – When people quit their stable professions to day trade or to flip houses, that is a bubble.
- Skepticism met with anger – You express skepticism on investing in something that has been popular, and you’re not just met with disagreement but also with anger, that is another sign. You see that in the crypto world where even mild questioning of their thesis is met with resentment. That is a bubble because who does not want to effortlessly get rich.
- Extreme predictions – The last feature of a bubble is extreme predictions. Bitcoin is going to a million. When you see such headlines, you can be sure of a bubble.
One more thing I would add to the list is when you see Wall Steet launch products around themes that are currently in vogue. Because Wall Street will sell anything people will buy. So, when you see things like an AI-focused fund and gold and uranium mining ETFs being marketed, you know that is a bubble.
The unfortunate problem with bubbles is that they can go on forever. Alan Greenspan, the then Federal Reserve chair, in a speech he gave at the American Enterprise Institute in December of 1996, warned that the stock market is in a bubble. Yet, the tech-heavy Nasdaq went on to quadruple in four years before the bubble eventually burst.
So even knowing that there is a bubble did not help. What do you do then? A few takes…
- Know why you are investing and for how long you are investing for. Build a plan around that using reasonable investments and you’ll do fine.
- FOMO is real but free lunches are few and far between. Be wary of hot tips and know that you’ll never see the full picture of other people’s finances.
- Expected return from any investment should make sense. I use the yield on the 10-year Treasury bond as a guideline. And ten years roughly matches the duration of any long-term investing. So, if that bond, the safest of all investments, yields four percent and if something else yields five, there is a risk. Understand that risk and invest accordingly.
- An investment today means cash flows now or in the future. Steer clear of investments that will never produce cash flows. You don’t have to know as much as Aswath Damodaran but understanding some basics on how business valuation works will save you from a lot of heartburn.
- And knowing some history only helps. It gives you the context on what to expect from real investing. You can deviate from what works but understand the risks before you deviate too much from it. Blowing up your life, taking chances, is never worth it.
Thank you for your time.
Cover image credit – Andrea Piacquadio, Pexels