What makes investing so hard?
Investors have to wrangle all kinds of issues: economics, financial reporting, asset structure, valuation. Maybe the most challenging issue we face is our own nature. We’re social creatures, something noted by observers thousands of years ago. We like to do what other people are doing. It makes us feel good to have company. If we go against the crowd it can feel like standing up against a herd of charging buffalo.
But strategists have long seen the advantages of going against prevailing opinion. “Never follow the crowd,” Bernard Baruch says. Sir John Templeton put it this way: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” The most profitable strategies come down to buying when others are pessimistic and selling when the crowd is most optimistic.
In the past three decades, we’ve seen bubbles inflate and then pop twice in the US: during the dot-com boom and bust, and again during the housing boom and bust. As a result, people now see signs of bubbles in all kinds of things: initial stock offerings, electric vehicles, digital currencies like bitcoin, trading frenzies like Robinhood and GameStop.
But can bubbles form when everyone is on the lookout?
Bubbles have been part of the investment landscape from the time of the first investment companies. Sir Isaac Newton got swept up in the fervor around the settlement of the “South Seas.” Besides being the one of the inventors of calculus and discovering the laws of physical motion, he served as Warden of the Royal Mint in the early 1700s and helped move England to the gold standard. Despite his immense learning, he lost as much as $20 million when the South Sea Bubble popped.
An investment fad isn’t the same as a bubble. A true bubble needs three ingredients: a mysterious new market, abundant enthusiasm, and easy credit. The real estate bubble was spurred by innovations in mortgage lending; the internet bubble grew on hopes of a new, digital economy; the Japanese real estate bubble of the late ‘80s inflated on dreams of “Japan, Inc.” becoming the world’s dominant economy.
Time Magazine cover from 1981. Fair Use.
The economic fallout from a popped bubble comes through the banking system. When investors lever-up to chase rising markets higher, the banks are left holding the bag when those markets collapse. When banks book these losses, they have to scale back and a credit-crunch ensues – often accompanied by a recession. In other words, a popped bubble isn’t an economic problem, its impact on lending and borrowing are.
This past weekend I went skiing at Waterville Valley. When I took a break on the outside deck of a lodge on the upper slopes, a group of young people near me were chatting about the money they’d made (and lost) trading Bitcoin. I wondered at the time if this was the proverbial “tip from a shoe-shine boy.”
The view from Bitcoin. Photo: Doug Tengdin
But if the banks don’t lend against an asset, it’s hard for that to become a systemic problem. The global economy runs on credit – for business, for personal finance, for governments. As long as the banks are strong and the financial infrastructure remains healthy, the economy should be able to handle the collapse of Bitcoin or GameStop or even the FAANG stocks.
Just don’t panic when everyone else does. That’s probably the best time to buy.