At the 2006 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting, Warren Buffett (Trades, Portfolio) was asked about his thoughts on the state of the commodity market.
He responded by saying the company was not involved in the commodity space at that time. Still, he went on to add some interesting thoughts on the topic of investment, speculation and price movements.
Buffett noted that fundamentals drive most asset prices in the beginning, but, at some point, speculation takes over.
When speculation takes over
This is not just limited to the commodity market. It is something investors need to be aware of at all times when investing in securities.
As Buffett went on to say:
"And with any asset class that has a big move, that's based initially on fundamentals, is going to attract speculative participation at some point, and that speculative participation can become dominant as time goes by."
The Oracle of Omaha also noted that as soon as an asset has a price history that looks attractive, people start "looking at an asset they have never looked at before" and get envious of others making a lot of money.
This is the basis of a speculative bubble cycle. Investors and speculators see others piling into an asset and try to join in on the speculative mania.
At the core of this mentality is the belief that one can get out before the rest of the herd. This can be an interesting psychological scenario.
I am sure any investor who has spent enough time in the market has found themselves in a position where they are watching others get rich and believe they know more than everyone else.
Most market participants have to believe they know more than everyone else. Every investor and trader is trying to take advantage of an opportunity, whether they believe it's a gap between intrinsic value and the current market price or an opportunity to take advantage of the market's momentum.
Every investor and trader has a plan to get in and out of the market and make money. They believe they can take advantage of the market environment. And if one believes they can take advantage of the market environment, they also have to believe they can get out before other market participants decide to start selling.
Unfortunately, it is impossible to know the right time to start selling as no one knows when the tide will turn, when a company's luck will run out or when geopolitical events will move against an investor's positions.
Even Buffett cannot escape this trap. He has experienced several situations during his long career where he has been caught off guard by company and market developments.
Leaving before the end
As Buffett went on to explain in 2006, most investors and traders who are betting that the price of an asset will continue to rise are like "Cinderella at the ball."
Everyone is enjoying themselves and they all think they are going to get out of there at midnight, just before they turn into pumpkins and mice. But not everyone can get out at the same time. There will be some partygoers who stay too late.
To try and avoid getting caught up in speculative manias, investors need to focus on the fundamentals and not be afraid to be too early to the party or too early to leave. It may also be sensible to try and prevent the investment decisions of others from impacting one's own mentality and ideas.
Moving against the herd like this is not easy. It requires practice and psychological strength. The only way to develop the required mentality is through training and reading. There are no shortcuts.
