An investment bubble occurs when a bandwagon mentality leads investors to rush to invest in assets with inflated prices. This further inflates the prices until an event triggers a crash, metaphorically, bursting the investment bubble that built up over a period of time.
One of the first documented speculative bubbles happened in 1637 in Holland when the price recently introduced tulip bulbs went to extraordinarily high levels, sometimes ten times the annual income of a skilled craftsman (many of whom foolishly mortgaged their assets to acquire tulip bulbs) and eventually collapsed. This event is referred to as the Dutch Tulip Bubble and large economic bubbles thereafter are often referred to as "tulip mania."
South Sea Company Bubble in England (1720) is another well-known bubble that led to great financial ruin for many investors. The company was established in 1711 with exclusive trading rights in Spanish South America. In exchange for trading rights, the company serviced the government debt. The company took on additional government debt by issuing stocks to investors who considered the monopoly of the South Sea Company as a great asset. Over the course of a single year, the price of the stock went up from about 100 pounds a share to almost 1,000 pounds per share, leading to an increased interest in investing from across the spectrum of society — from peasants to lords. When the inflated stock prices reverted back, the crash led to several bankruptcies and enormous losses for investors.
Other famous bubbles include the Mississippi Company bubble (1720) , Railway Mania (1840s), Florida Speculative Building bubble (1926), Roaring Twenties Stock Market bubble (1922-1929), Poseidon bubble (1970), Japanese Asset Price bubble (1980s) and Dot-Com bubble (1995-2000).
The Roaring Twenties Stock Market bubble is one of the most notable bubbles since its aftermath contrasts so starkly with the Great Depression which shook Americans to their core. During the 1920s, the social, artistic and cultural dynamism led to an over optimistic view of the economy. It all changed with the stock market crash on Oct. 19, 1929, also known as Black Friday, that culminated in the Great Depression era that affected millions across the world.
Dot-Com bubble, also known as the Internet bubble during the late 1990s saw an increase in the valuations of companies that derived their growth from the recently booming Internet sector and related fields. The Internet boom was assumed to last forever with positive cash flows and other traditional metrics not being the barometer of performance for start-ups. The bubble burst in 2000 from levels exceeding 5000, and the Nasdaq has yet to recover. Click here for a list of the top 10 dot-com flops.
More recent is the Housing Market bubble in the United States during which the real estate prices reached peak valuations during 2004-2006. During this time, many homeowners borrowed against home equity while several others bought the real estate hoping that the price increase would be forever. The prices saw a decline starting in 2006, leading to increased mortgage defaults, foreclosures and the subprime mortgage industry collapse in 2008 that was the foundation of the 2008-2009 recession.
Lessons to be learned for retail investors:
While all of the above bubbles have been very profitable for the few investors who bought at a low price and sold high, at the peak of the bubble, many investors and homeowners have seen life-changing losses in their portfolios as a result of bubble bursts. Retail investors, who are risk-averse by nature, usually get on the investing bandwagon when there is a widespread optimism about a particular asset, which is usually when the asset is nearing its peak price. Due to increased demand and limited supply, this inflates the prices of the underlying assets further, enticing other disinterested investors as well. Since it is very difficult to predict the start of the decline of an asset price, retail investors are led to believe that an asset price is meant to go up forever.
Hence, a retail investor should focus on underlying asset quality and the related cash flows before making any investment instead of riding the bandwagon. This happened during the dot-com bubble when any company with an "e" prefix was valued highly by investors. As can be seen from all of the above examples, when there is a perception of riches to be made, many individual investors get caught up in the “greater fool’s” game and forget to ask the simple question, “How much?".
In "The Intelligent Investor", Benjamin Graham identified a simple question composed of these two simple words that are often forgotten by stock buyers: how much? A hot tip, technicals on a chart, or simple momentum have led many stock into purchases without fundamentally analyzing the company’s intrinsic value or, "how much" it's worth. Professional investors, who should know better, are just as prone to toss out the fundamentals and jump on the bubble bandwagon.
In his article, “Temperament Makes Warren Buffett a Genius”, Gurufocus contributor Ravi Nagarajan makes the key point that investing success requires the right temperament and patience, in addition to solid analytical skills. In quoting author Ronald Chan, he writes:
People like to ask Buffett how he values an investment, but a question like that is not too meaningful. He does not do it any differently than an average investor. In fact, his investment calculation model is probably the same as what we all learn from financial textbooks. The real distinction, then, is how Buffett equips himself with the right mental capacity to stick to his investment principles year after year, regardless of the prevailing environment.
An investor needs to understand the dynamics affecting the movement of an asset price and should make a judicious use of information made available to him or her. I am likely preaching to the choir by writing this on a sophisticated value investing site, but we cannot remind ourselves enough that, if the fundamentals don’t add up, and someone is telling you “this time is different” and encouraging you to invest in a "hot" stock or other asset, do yourself a favor and run away.
One of the first documented speculative bubbles happened in 1637 in Holland when the price recently introduced tulip bulbs went to extraordinarily high levels, sometimes ten times the annual income of a skilled craftsman (many of whom foolishly mortgaged their assets to acquire tulip bulbs) and eventually collapsed. This event is referred to as the Dutch Tulip Bubble and large economic bubbles thereafter are often referred to as "tulip mania."
South Sea Company Bubble in England (1720) is another well-known bubble that led to great financial ruin for many investors. The company was established in 1711 with exclusive trading rights in Spanish South America. In exchange for trading rights, the company serviced the government debt. The company took on additional government debt by issuing stocks to investors who considered the monopoly of the South Sea Company as a great asset. Over the course of a single year, the price of the stock went up from about 100 pounds a share to almost 1,000 pounds per share, leading to an increased interest in investing from across the spectrum of society — from peasants to lords. When the inflated stock prices reverted back, the crash led to several bankruptcies and enormous losses for investors.
Other famous bubbles include the Mississippi Company bubble (1720) , Railway Mania (1840s), Florida Speculative Building bubble (1926), Roaring Twenties Stock Market bubble (1922-1929), Poseidon bubble (1970), Japanese Asset Price bubble (1980s) and Dot-Com bubble (1995-2000).
The Roaring Twenties Stock Market bubble is one of the most notable bubbles since its aftermath contrasts so starkly with the Great Depression which shook Americans to their core. During the 1920s, the social, artistic and cultural dynamism led to an over optimistic view of the economy. It all changed with the stock market crash on Oct. 19, 1929, also known as Black Friday, that culminated in the Great Depression era that affected millions across the world.
Dot-Com bubble, also known as the Internet bubble during the late 1990s saw an increase in the valuations of companies that derived their growth from the recently booming Internet sector and related fields. The Internet boom was assumed to last forever with positive cash flows and other traditional metrics not being the barometer of performance for start-ups. The bubble burst in 2000 from levels exceeding 5000, and the Nasdaq has yet to recover. Click here for a list of the top 10 dot-com flops.
More recent is the Housing Market bubble in the United States during which the real estate prices reached peak valuations during 2004-2006. During this time, many homeowners borrowed against home equity while several others bought the real estate hoping that the price increase would be forever. The prices saw a decline starting in 2006, leading to increased mortgage defaults, foreclosures and the subprime mortgage industry collapse in 2008 that was the foundation of the 2008-2009 recession.
Lessons to be learned for retail investors:
While all of the above bubbles have been very profitable for the few investors who bought at a low price and sold high, at the peak of the bubble, many investors and homeowners have seen life-changing losses in their portfolios as a result of bubble bursts. Retail investors, who are risk-averse by nature, usually get on the investing bandwagon when there is a widespread optimism about a particular asset, which is usually when the asset is nearing its peak price. Due to increased demand and limited supply, this inflates the prices of the underlying assets further, enticing other disinterested investors as well. Since it is very difficult to predict the start of the decline of an asset price, retail investors are led to believe that an asset price is meant to go up forever.
Hence, a retail investor should focus on underlying asset quality and the related cash flows before making any investment instead of riding the bandwagon. This happened during the dot-com bubble when any company with an "e" prefix was valued highly by investors. As can be seen from all of the above examples, when there is a perception of riches to be made, many individual investors get caught up in the “greater fool’s” game and forget to ask the simple question, “How much?".
In "The Intelligent Investor", Benjamin Graham identified a simple question composed of these two simple words that are often forgotten by stock buyers: how much? A hot tip, technicals on a chart, or simple momentum have led many stock into purchases without fundamentally analyzing the company’s intrinsic value or, "how much" it's worth. Professional investors, who should know better, are just as prone to toss out the fundamentals and jump on the bubble bandwagon.
In his article, “Temperament Makes Warren Buffett a Genius”, Gurufocus contributor Ravi Nagarajan makes the key point that investing success requires the right temperament and patience, in addition to solid analytical skills. In quoting author Ronald Chan, he writes:
People like to ask Buffett how he values an investment, but a question like that is not too meaningful. He does not do it any differently than an average investor. In fact, his investment calculation model is probably the same as what we all learn from financial textbooks. The real distinction, then, is how Buffett equips himself with the right mental capacity to stick to his investment principles year after year, regardless of the prevailing environment.
An investor needs to understand the dynamics affecting the movement of an asset price and should make a judicious use of information made available to him or her. I am likely preaching to the choir by writing this on a sophisticated value investing site, but we cannot remind ourselves enough that, if the fundamentals don’t add up, and someone is telling you “this time is different” and encouraging you to invest in a "hot" stock or other asset, do yourself a favor and run away.
