Following on from “Three Common Investment Mistakes” and the impact of behavioural finance on investing, let’s take a quick look at investment bubbles.
Most of you are familiar with the US housing crash over recent years. Some of you may also remember the dot.com craze in the 1990s. Those would be examples of bubbles breaking.
In his very interesting work, The Ascent of Money, Niall Ferguson lists 5 stages of an investment bubble. The headers are his. The editorializing is all mine. So do not blame Niall.
Changing economic circumstances create an opportunity for business or industry.
Think of the technological developments in the early 1990s, especially those relating to the internet. Amazon and Ebay are two survivors from that era.
Company sales and profits rise as they take advantage of the changed economic circumstances.
Investors get excited and buy into the growing companies. This causes share prices to rise. Which, in turn, attracts more investors and causes the stock to increase even more. Basic laws of supply and demand. The more people want shares and the less that existing shareholders wish to sell, the price must rise.
The company begins to be highlighted on the business channels and stock recommendation lists.
More investors buy as publicity grows.
3. Mania (Bubble)
The general media pick up this feel good story of a company growing and investors making money.
You take a taxi ride. Your driver recommends the stock.
Now the suckers novice investors, speculators, and swindlers start buying.
Insiders and skilled investors realize that future earnings cannot justify the insane share prices and begin taking profits. This stems the price climb.
Financial experts on the business channels begin to confidently claim that the companies are overpriced and that they had previously predicted this peak. They always do.
As demand evaporates and share price begins to decrease, the remaining rats in the sinking ship shareholders run for the exits, taking whatever they can get for their shares.
This causes the stock to plummet. Many people lose significant money.
The main-stream media does front page stories on kindly grandmothers who have lost their pension money and now share their cat’s food for dinner. Of course, they call for more government supervision and bailouts for the masses. There is no mention as to why a pensioner was putting money into highly volatile ventures.
Remind anyone of the current housing situation in the US?
Are there any industries, companies or economic situations that might currently be heading toward a bubble?
Climate Change and its implications for “green” business. There has been a rush with industries to take advantage of the hysteria created about CO2 emissions. Electric cars, solar powered homes, wind energy, a ban on plastic water bottles, NBC (literally) greening their television studios. Now that the data is under scrutiny due to its manipulation by the anti-global warming scientists (google East Anglia data manipulation),there may be a slowdown in these fields. If so, investors may jump ship, causing a sharp fall in share prices.
Gold may be another potential bubble. Look at the recent price history. We are at the point where you cannot turn on the news without a story concerning gold prices. Some would say it is exhibiting classic bubble behaviour. Others would argue that given US economic policies, that it is a shrewd hedge that will only go higher.
And that is the trouble with investment bubbles. In hindsight, they appear obvious. But when the price is still rising and everyone is buying, there are many reasons to believe the good times will continue.
There may be other examples that you can think of in your own world. And not just in the stock market. The newest, hottest night club that has lines a mile long, but in one year will be empty. That Guitar Hero you prayed for last Christmas, now gathering dust in the closet.
Be on the lookout for the next Zhu Zhu pet. Where can you buy one now? Where will it be buried a year from now?