“This time is different” may be the scariest phrase ever used in investing. It is the common theme of speculative market bubbles. And though it is easy to name numerous times the phrase has been batted around and been completely wrong, I cannot find even one instance in which I would say it was convincingly right. That’s what’s so scary.
Market bubbles are not new, nor are they confined to stocks. Regardless of the asset involved, bubbles tend to have a lot in common.
What Is a Bubble?
A bubble occurs in a market when an asset or a group of assets climbs in price to attain a price far greater than the underlying value. It can be a single stock, a sector, or even an entire market.
A market bubble could also occur in commodities, debt, or real estate. Any asset could conceivably have a price bubble. Markets facilitate bubbles by allowing for the ready and rapid exchange of ownership. The market itself doesn’t cause bubbles, but simplicity of trading makes it easier for investors to build bubbles.
Traditional financial theory is grounded in the efficient market hypothesis (EMH), which indicates that prices reflect true value as investors accurately incorporate all existing information into their decisions. Bubbles are clear violations of the EMH and are better explained by behavioral finance than traditional finance.
A market bubble is driven by hype, not value. Since value is thrown out the window, the universal statement of bubbles comes in as a justification: “This time is different.” The meaning is that conventional valuation can be thrown out the window due to the disruptive effects of whatever is violating the laws of finance and common sense.
Bubbles Have a False Narrative
Bubbles always have a story to tell. In the internet era, it was that traditional valuation was irrelevant because the internet was going to displace everything. The narrative has to be believable, and it has to be pervasive.
The narrative fuels unsupported price increases, which increase until something causes the bubble to burst. When that happens is not predictable. Many people think they’ll get out before the fall, but the fall occurs without warning.
The narrative is the basis on which investors build a foundation of unbridled enthusiasm. It may be reported by the media, likely without intent.
It may be reported as this is what investors are saying, without any endorsement of the story. Still, its prevalence fuels its credibility. It is so common that people may believe it has to be true. The irrational optimism is fueled by a number of investor biases.
Bias and Bubbles
If investors truly priced assets based on existing information, there would be no price bubbles. Bubbles are caused by speculation; they are fueled by bias. The short answer to the question of what causes bubbles: People do.
Overconfidence is a bias where investors overestimate their ability to evaluate information and make a decision. Most investors think they are above average. Overconfidence is a significant problem in investing; overconfident investors underperform their peers.
Confidence is good; over anything is “over” for a reason — as in too much.
Overconfidence is too much confidence; you could call it unwarranted confidence, and it costs investors money. Overconfidence is correlated to bubbles.
Herd behavior is simply following what others do. This is related to FOMO (the fear of missing out). People may act on the story even though they doubt its veracity. People are afraid of being wrong, and they mistakenly view failing to achieve a gain that someone else is making as their loss.
Confirmation bias is our tendency to listen to the information that supports our existing beliefs and to discount information that conflicts with those beliefs. We find the evidence to support what we already believe. Once we take the bait, we find ways to enjoy the hook.
Group dynamics also come into play in perpetuating bubbles. Groupthink in particular incorporates several behaviors that are conducive to perpetuating bubbles.
In groups, people tend to conform. They don’t want to be the one speaking out at the watercooler; they are not likely to stand up for what they believe is the truth. Even if they see the irrationality of “This time is different,” they aren’t likely to speak up.
What to Do About Market Bubbles
What, then, is an investor to do? The answer is surprisingly simple.
Investors don’t chase market bubbles; speculators do. Investing and speculating are not the same thing. Investors make decisions based on knowledge and historical precedent and have a reasonable expectation of a long-term positive result based on that analysis.
Speculators extrapolate present phenomenon into the future in the hopes of achieving an outsize gain.
They’re different techniques.
Investors can speculate. When doing so, they tend to follow some basic rules. The first is to not speculate with more than you can afford to lose.
This would usually limit the funds you speculate with to fun money (outside of your investment portfolio) or a single digit percentage of your portfolio. Investors don’t bet the house, and speculating is a form of gambling: There is no reasonable assuredness of a positive outcome; it is based on chance.
If an investor does speculate, they will also hedge their bets. A stop-loss order can limit the downside of a speculative investment. And if the asset moves up in price, the stop-loss can be moved up accordingly, preserving at least a portion of gains.
Never, never, never use debt in speculation. Debt magnifies the results of an investment’s performance. If you purchase an investment with half cash and half debt, you have magnified your performance by a factor of two. And that is in both directions: up and down.
Debt enables you to lose more than you invested.
This violates the precept of not investing more than you can afford to lose. If you invest cash and lose your money, then you have suffered a loss.
If you invest with debt and lose your money, there are prolonged aftereffects; you still need to pay back the debt. Debt and risk do not mix well. Debt multiplies negative effects, and most investors cannot afford magnified risk and its potential long-term negative ramifications.
The Bottom Line
Bubbles are not a new phenomenon. They have been around for centuries. And they share some common characteristics. They are fueled by unreasonable behavior of people. There is no rational reason to follow a bubble, but people do — otherwise there would be no bubble.
Speculating is not investing, nor is investing speculating. They’re different. Bubbles are driven by speculation, which is a form of gambling.
It is OK to speculate, but not OK to speculate with more than you can afford to lose. Every time that “This time is different” has happened it’s always been the same. It hasn’t been different. And those who took excessive risk incurred excessive losses.
There may be some spillover into other markets when the bubble bursts. But those who are invested for the right reasons are positioned to weather the storm. Bubbles will continue to occur. Whether or not you’re involved in them is up to you.
