Although the explosion in financial complexity has made it so that speculative activity can have a much bigger effect on the overall system, the phenomenon of the bubble itself goes back a long time. At the 2006 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual shareholder meeting, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were asked to comment on whether they saw a bubble in the commodity market. Their explanation of how bubbles arise is applicable to any asset class.
Untethered from fundamentals
Speaking about the boom in copper prices, Buffett explained how bubbles form:
“Like most trends, at the beginning it’s driven fundamentals, and at some point, speculation takes over. The fundamentals cause something that people looked at for years without getting excited about. Fundamentals change the picture in some way...It’s that old story of what the wise man does in the beginning, the fool does in the end.
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.”
In other words, every bubble begins with something legitimate. Some change in the underlying supply or demand for a commodity or stock causes the first wave of investors to desire more of it. Successive waves of investors see the price rising and buy more of it in expectation of future price increases.
Buffett uses the classic example of the 17th century Dutch tulip bulb bubble. At one point, there was some real reason why buyers preferred tulips to dandelions, causing the price to go up somewhat. After a while, buyers became driven by greed more so than they did by a rational assessment of the tulip’s value:
“Once a price history develops that causes people to start looking at an asset that they never looked at before, and to get envious of the fact that their neighbour made a lot of money without any apparent effort because he saw this early and so on. It takes over.”Â
The fear of missing out is a key driver behind the formation of bubbles. Once people become more preoccupied with matching the returns made by their peers than with making rational investment decisions, they are well on their way to getting swept along by the tide of speculative activity.
Successful speculation does not rely on the appraisal of the fair value of an asset; rather, it is a product of whether the speculator is able to get out in time before the bubble inevitably bursts. Buffett went on to admit that he is not particularly good at timing these things (and neither, it seems, is anyone). Successful investing results can be replicated with hard work and adherence to a system. I have yet to find a system for successful speculation that can be consistently followed.
Disclosure: The author owns no stocks mentioned.
Read more here:
- What Lies in Store for Financial Stocks?
- Seth Klarman: In Defense of Uncertainty
- Seth Klarman: Exploiting Erratic Market Behavior
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