Bubbles Are Not Irrational

The word “bubble” can be an emotional trigger for investors, immediately stoking fear and anxiety. Pundits and economists may refer to bubbles as irrational market anomalies, but there’s much more to the story than that. Here is some context so that you can understand the investor mindsets and strategies that spawn them.

Rational bubbles

Day trading in ‘01, crypto investing, house flipping in ‘07, Beanie Baby collecting, and tulip bulb mania are examples of short-term investments with exposure to market bubbles. Experts talk about how bubbles are created by irrationally exuberant investors, but that’s a misleading term. The short-term investors who create bubbles are rational people, they’re just following a different set of investing rules and chasing a different kind of goal than traditional investors. Bubbles form when too many short-term investors chase the same quick return strategy on the same asset at the same time.

Why do speculators exist?

Short term speculators exist because competition in investing is fierce and no one wants to feel average. “Customers are divinely discontent. Their expectations are never static – they go up. It’s human nature. Yesterday’s ‘wow’ quickly becomes today’s ‘ordinary’.” – Jeff Bezos. Long-term investors make up the bulk of global investment capital but short-term investors who hop around from opportunity to opportunity can leave prices to slosh around in their wake.

Bubbles form because money chases returns

Whenever an asset’s price shoots up, short-term investors rush in to score quick and easy wins. This happens predictably and without fail. Bubbles are disorienting to “normal” investors because short-term investors ignore the fundamentals, like earnings or the financial health of a company. If a trader thinks they can buy something today for $100 and sell it to the next person for $101, they don’t care what they are buying or what the balance sheet says.

That’s rational behavior. There’s no need to worry about long-term fundamentals when your investment horizon is tomorrow or even ten minutes from now. The lack of investor interest in fundamentals makes bubbles unsteady and susceptible to collapse at the first sniff of bad news. When bubbles do collapse they can surprise the hell out of you in ways you never imagined.

Who is Hyman Minsky? And why should you care?

University of Chicago mathematician and Harvard economics Ph.D. Hyman Minsky gave us the financial instability hypothesis. Simply put:

•                People get optimistic when markets are stable

•                People take out more debt when they are optimistic

•                More debt creates market instability

He’s describing an interesting cycle where stability creates optimism that leads to more investing, which creates instability. A risky asset’s price will rise as more investors perceive it as stable, making it even more risky. The contrarian investor is keenly aware of this concept. Warren Buffett addresses this when he says, “Be fearful when others are greedy and greedy when others are fearful.”

So what’s that mean for investors right now? Market headlines have been particularly negative in 2017 and 2018 despite positive performance. Minsky would say this is a sign of a healthy market – there’s no unrealistic sense of serenity and stability to drive up prices.

A diversified portfolio should continue to do well when market controversy and media drama are high. Skepticism is a sign of market health. We need a balance of positive and negative thoughts to drive decent long-term returns and keep bubbles under control.

Twice already in 2018

Are there bubbles today? Yes. We’ve already experienced two major market bubble blowups in 2018. The VIX bubble and the Bitcoin bubble both erased billions of dollars of value. You probably didn’t feel it in your pocket because you probably weren’t heavily invested in either of these untraditional markets.

The VIX bubble drove one fund worth nearly $4 billion down to $0. Investors who lost money on the VIX bubble were focused on collecting “easy money” by shorting the VIX, a statistical index that measures volatility in financial markets. These investors bet the VIX would go even lower from its already low lows. This has been a popular trade for a few years. Some assumed it would continue indefinitely. They were wrong. It was profitable until suddenly it wasn’t.

The other bubble, the Bitcoin bubble, was a -50% loss from the high this year. Or $20,000 down to $10,000 as of this writing. It’s not clear if the Bitcoin bubble has fully popped, or ever will, but with short-term speculators dominating that market, the price of Bitcoin can go anywhere on any given day.

How much should you have paid for a technology stock in 2001?

If you are a 10 year investor, the answer depends on your analysis of the industry and the ability of the management team. If you are a 1 year investor, the answer depends on if we are going to enter a bull or bear market. If you are a single day investor, the answer is it doesn’t matter because you’re going to sell it the second you see a profit. All of these investors exist simultaneously and bubbles form when too many investors fall into the short-term category.

What it means to be a long term investor

Short-term speculators can make money. Some make a lot. But if your goals, like most investors, are preservation of capital and return on capital, short-term speculation is not the answer.

We advise on building long-term diversified portfolios to fit an investor’s long-term investment goals, capabilities and timeframes. A long-term investor cares about steady and disciplined investment practices. A diversified investor doesn’t over-rely on any single asset or asset class. Own a lot of everything and stay invested. Markets can and do swing more than the fundamentals say they should. But holding on for the long term makes those temporary swings almost meaningless. And what other investors do in the short term to create market volatility is mostly a distraction, not worthy of attention.

Bonus: How can you make money on a bubble?

All that being said, it can be fun or at least interesting to seek a profit in bubble-prone assets. But you need a plan and you need to stick with it. The only repeatable speculation strategy I’ve personally witnessed and experienced is: Get in early, keep it small, be dispassionate and act quickly.

When you have $1,000,000 in assets or more, buy $1,000 to $5,000 of a cryptocurrency or new tech stock. With small investment sizes you are better equipped to make quick decisions and ride the momentum to eventually sell at a profit. You are essentially a long-term holder, even though you are a speculator. The more you put in, the more likely you are to hesitate, overanalyze and risk missing your chance to sell at a profit.

If you are fortunate enough to sell at a profit, repeat the process with the same small amount and same strategy. If prices collapse, you’ve only lost a small amount while satisfying your speculative curiosity.