Bubble Trouble

It seems that we are living in an age where bubbles are almost commonplace. The Internet bubble of the late 1990s and early 2000s and the housing bubble of the mid-2000s are recent examples of bubbles at work. Due in part to this rapid succession of bubbles, it seems now that everyone is on a hair trigger to be the first to declare every notable price rise (or fall) a bubble.

Bubbles, properly defined, are rare things.

However, the past decade we seem to be caroming from one boom-bust cycle to the next. Some might lay the blame for this at the foot of the Federal Reserve for fostering risk taking, but for our purposes the underlying cause is irrelevant. This is because bubbles have been a feature of markets across time, culture, and geography.

The defining characteristic of a bubble is price. Bubbles are characterized by a rapid increase in price. Those prices rise above any reasonable indication of intrinsic value. The rise in price is accompanied

by a marked increase in public participation in the market and is supported by claims of a fundamentally new pricing regime. The final piece of the bubble puzzle is the inevitable rapid decline in price that washes away whatever optimism existed prior.

The great challenge of bubbles is that they can really only be identified in hindsight. A bubblelike market can remain aloft far longer than its detractors can believe. As long as the market's apogee is still unknown, there is always a ready source of market defenders. It takes the passage of time and a clear peak in price to convince the vast majority of market participants that a bubble did indeed take place.

Most discussions of bubbles focus on price, in part because a bubble is defined by the rapid rise and subsequent fall in price. It may seem strange that we have included a discussion of bubbles in a chapter devoted to risk. However, bubbles not only play havoc with expectations about asset prices but also have a large effect on investors' emotions and their changing tolerance for risk. Indeed, much of the recent research on bubbles emphasizes how discount rates, or investors' willingness to take on risk, change over time.

If you assume that the intrinsic value of a stock (or market) is generally slow moving, then a rapid increase in price, by definition, increases the stock's risk. If the stock were to revert to fair value, a loss is therefore more likely. The problem is that our emotions give us very different messages. As a stock's price increases, it provides positive feedback to investors that their initial decision was correct. For those investors still on the sidelines, it gives them the emotional kick to move off the sidelines.

This cycle plays itself out in the markets over scales large and small and over time frames short and long. Where a bubble differs is that it subsequently induces individuals who don't normally participate in markets to join in. It also helps that journalists, albeit unconsciously, can get caught up in bubbles as well — especially how journalists converge on certain language surrounding market moves.

 A bubble also induces people to act in clear violation of their own, more reasoned judgments.

As Meir Statman writes, “Investors everywhere run in herds, large or small, bullish or bearish.”

 These herds can play a disproportionate role in individual decision making. Statman notes that, at the height of the Internet bubble, a poll showed that investors

 knew stocks were overvalued but remained in the market in hope of capturing some further upside. This willful suspension of disbelief makes it nearly impossible for investors to recognize when the inevitable trend change occurs.

We could have included in the definition of a bubble that most investors, even those who got into a market relatively early, don't end up profiting from a bubble. To profit from a bubble, one needs to both buy and sell. Nearly all investors, large and small, focus on the purchase decision with little or no thought to their exit plan. To many the risk of not being in the market seems far more urgent than any future price decline. That is why investors who escape scot-free from a bubble are rare indeed.

Even in the case of a company such as

, which successfully threaded its way through the bubble, it has taken a full decade for

 stock to retrace its losses from its peak in 1999. Remember, this company is maybe the best-known survivor of the bubble. Other companies and their investors are not so lucky. The point is that most investors in

 likely did not have the wherewithal to hold the stock for the decade that followed.

This shows the high stakes that are involved in market dislocations like those seen in the Internet bubble. As mentioned earlier, we are still living with the aftermath of the housing bubble with home price indexes still showing little sign of recovery and a backlog of houses waiting to change hands. A bubble is a rare event that increases the stakes of investing for both the individual and the economy as whole.

That is not to say that every aspect of a bubble is necessarily bad. Daniel Gross makes the case that in some instances the aftereffects of some bubbles actually provide a public good to the economy.

 Gross explains how the construction of the railroads in nineteenth-century America provided generations of benefits to the country despite the poor financial performance of the original rail companies. One could also argue that were it not for the Internet bubble of the prior decade, we would not be experiencing the numerous benefits of what is best described as Web 2.0.

If bubbles represent a case study in risk, what can be done to combat them? One of the clear implications is that investors of all stripes need to have a plan. This is a theme we will return to time and again.

 In this framework, a bubble is simply another event against which investors execute their plan. Of course, that is easier said than done.

Having some experience with bubbles is desirable, but that experience is not exactly something one can acquire easily. A substitute is having some understanding of the history of financial markets. A broader understanding of how markets experience these cycles time and again, under widely different circumstances, can help gird one for the challenges that follow.

Achieving this wider understanding is really a larger component of trying to put a bubble into context. Investors also need to put the effect of a bubble into context within the framework of an overall portfolio. Bubbles tend to have a spotlight effect by forcing all of an investor's attention onto the bubble to the detriment of the portfolio as a whole. When viewed in light of an entire portfolio, decisions regarding a bubblelike asset become clearer.

This idea of garnering some broader context may require outside intervention. Stephen P. Utkus notes the importance of seeking out third parties to help bring some additional information and judgment into a situation.

 Bubbles are characterized in part by groupthink, and therefore consulting with someone who is not part and parcel of the group can bring some much-needed perspective.

Bubbles are insidious because they affect the way investors manage and process information. Nor should we be sanguine that identifying bubbles in real time is an easy task. Perhaps because it is so difficult to do, Benjamin Graham suggested investors never go below 25% equities over above 75% equities.

 If bubbles represent an overshooting of price to the upside, then the flip side of a bubble is a panic. Panics, however, play out under different circumstances than bubbles do and toy with our emotions in a very different way.

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