Behavioural Finance and Markets International

Forever blowing bubbles

Be fearful when others are greedy and greedy when others are fearful.

– Warren Buffett


Buffett uses this mantra every day, along with his two other ground rules for running his investment firm Berkshire Hathaway:

  1. Never lose money.
  2. Never forget rule number 1.

So why does the 90-year-old legendary investor hold these core mantras? One possible answer can be found by considering the history of investment bubbles.

One of the first recognised “bubbles” was what we now call “Tulipmania”. This took place in 17th century Netherlands and concerned the market for small tulip bulbs. The bubble was kickstarted by the aristocracy buying tulip bulbs for increasingly higher prices, as they were seen as a luxury indulgence. Many working-class people began to get involved in the market; since they could see how much money others were making, they had no qualms about paying extremely over-inflated prices.

This is a typical example of irrational herd mentality. The bubble became so extreme that some investors even took out loans against their own homes to buy into the market. At the height of the market, a tulip bulb could have sold for the same price as a small Dutch house. Issues arose when the market crashed due to a sudden lack of demand for the bulbs, with tulip prices plummeting by up to 99% in 1637. This ruined many people’s livelihoods, but worst of all, most were working-class families.

Now why is this interesting today? Although company shares were not being bought and sold during Tulipmania, the nature of the bubble remains very similar to a stock market bubble. People cared less and less about the intrinsic value of the flowers, and fixated solely about one thing: getting in on the profits. This blind greed and lack of due diligence (both irrational and driven by herd behaviour) is at the centre of almost every economic bubble.

Moving on to the 1990s, internet-based and technology companies such as Pets.com and Amazon were becoming ever-more popular in almost every international stock market. Herd mentality drew many investors and speculators all to do the same thing – buying so-called dotcom companies. The internet companies themselves were even using mottos such as “get big fast” and “get large or get lost”. Between 1995 and 2000, the Nasdaq Composite stock market index gained 400%. But by late 2002, it had lost almost 78% of its peak value.

Once again, greed and eagerness to “get rich quick” led a frenzy of bullish speculators to the sector. People began to discard traditional valuation metrics and the market prices were continually pumped up. In this case, there were two main reasons for such a bubble, and they mirror “Tulipmania” identically: blind speculation with little investment rationale or valuation metrics, and the use of high levels of leverage (using borrowed money to fund investments) in order to maximise profits. Both characteristics are extremely common in bubbles.

The biggest profit-seeking financial bubble of all took place in 2007/08 and was founded upon the U.S. housing market. Throughout the course of the early 2000s, prices in the housing market began to rise, thanks to low interest rates and a willingness by US banks to lend freely with very little risk control. People who previously would never have qualified (known as sub-prime mortgage holders) for even one mortgage were now being granted loans for two or three properties and up to 110% of the value of the assets themselves. Why would the banks do this? It was because the people giving the loans were making so much money in commissions, and because there was insufficient regulation in place to stop them.

Not only was the US housing market beginning to over-inflate, but the banks providing these mortgages were selling also the debts onwards to investors. They were packaged into instruments known as mortgage-backed securities (MBS), which proved highly lucrative for the investment banks. So much so that once again they took on too much risk without heeding the cautionary signs, such as irrationally large spikes in demand for these instruments, all because they were making so much money.

When the bubble popped, the ensuing collapse of the US housing market led to the crash of the global financial sector as a whole. The world economy suffered the consequences. Worldwide stock market crashes followed, and the US, along with much of the rest of the world, went into a recession. There was mass unemployment, with many people losing their life savings, their jobs, and their homes.

This is another example of what can happen when a large mass of people throw huge sums of (often highly leveraged) money at an investment idea, driven by greed and a fear of missing out on large returns. However, once again we see that the pursuit of “getting rich quick” can often end in disaster.

We are today in uncharted territory, with a relatively new investment vehicle, “Bitcoin”, which is enjoying mass private sector support, but which is also the subject of much intense debate. Essentially, Bitcoin and other similar “crypto-currencies” are decentralised, i.e. with no government or institutional control over them. They are untraceable and many people (especially criminals) find this anonymity attractive.

Perhaps Bitcoin will never be a veritable currency. However, as former Governor of the Bank of England Mark Carney has said, “The crypto-assets in your digital wallets are unlikely to be the future of money… but that is not meant to dismiss them.” It is conceivable that Bitcoin could become a more mainstream investment vehicle, but it is currently extremely volatile, and its price only rises and falls due to investor sentiment and speculation without any other method of valuation.

We return to Warren Buffet and his sustained success over a very long career. Clearly, he has been supremely skilled at making strong financial returns in the stock market. More importantly, by following his two rules, Buffett may have lost small sums of money along the way, but he has never exposed his company and investors to being wiped out financially.

Buffett refuses to invest in bubble-like markets or industries that he doesn’t understand. Through this strategy, he has rarely ever been hit hard by large stock market crashes and is always in a position to benefit when one arrives. In short, he “get[s] greedy when others are fearful”.

Notably, Buffett refuses to invest in Bitcoin… will this prove to be a bubble too?

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