Bubbles

Bubbles

Don’t get caught holding the bag.

Just what is a speculative bubble? The Oxford English Dictionary defines a bubble as “anything fragile, unsubstantial, empty, or worthless; a deceptive show. From 17th c. onwards often applied to delusive commercial or financial schemes.” The problem is that words like show and scheme suggest a deliberate creation, rather than a widespread social phenomenon that is not directed by any central impresario.

—John Kenneth Galbraith[1]

Bubbles can emerge from market interactions without a single clear cause or deliberate fraud. A financial bubble occurs when the price of an asset increases an enormous (even exponential) amount in a short time due to buyers expecting continued price increases.

As with anything, the price of an asset, such as a stock, is set by supply and demand. The more people expect to be able to profit by speculating in the asset, the higher the demand, and the more the price rises. However, sustained price increases are not what makes a bubble. To be a bubble, it needs to eventually pop. Once people stop expecting further price increases—which tends to mean they expect the price to drop, not just stay the same—they rush to sell, to avoid losing money. Supply suddenly soars, demand vanishes, and prices plummet, causing even more investors to flee.

During the early stages of a bubble, many fortunes are made. But as knowledge about sharply rising prices spreads, more people enter the bubble on less favorable terms. Often, bubbles become truly divorced from reality once growing numbers of people who are far outside their circle of competence—the businesses and assets they understand (a model discussed in volume 1) start buying. People end up buying on the mistaken assumption that the immediate past is an accurate picture of the immediate future; there is a “contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising.”[2] People don’t understand the economics of what they are buying; they just don’t want to miss out on the gold rush.

Beware of competing with those who have different time horizons to you.

—Morgan Housel[3]

Even those who call out the bubble can get caught up in the excitement. “As a bubble expands, some skeptics begin to disregard their own judgment because they feel that everyone else simply couldn’t be wrong.” [4] Basically, it’s really hard to sit on the sidelines while it seems that everyone else around you is making tons of money with minimal effort. However, any change in behavior by previous naysayers just serves to amplify the bubble, pushing it to its breaking point. Because “over time, the quality of information that can be gleaned from the behavior of others becomes worse and worse,”[5] a social proof situation is created, wherein it feels almost irresponsible not to jump on the bandwagon.

When bubbles pop, which they always do, later entrants into that market are worse off. Many people find themselves holding “assets” that are now worth less than they paid for them.

Irrational human behavior is a direct contributor to the life cycle of a bubble. Thus, they are partly a social phenomenon, with analogous applications outside of economics. Think of fashion trends: Every generation has to contend with a new look or style of clothing that appears out of nowhere and that, within months, everyone seems to be wearing. Then, one day, somehow that trend is no longer cool, and we’re stuck with high-priced items that we no longer want to wear.

A couple of lessons you can learn about bubbles are, first, that your assumptions about the future influence your future and, second, that success can sow the seeds of failure. When you assume a good time is going to carry on indefinitely, you make decisions that can have far-ranging impacts on your lifestyle down the road. And when it comes to successful products, making something ubiquitous is not the same as making it indispensable.

Speculative enthusiasm can finance experiments that would otherwise struggle to attract investment. Some may prove useful after the excitement fades. That possibility does not make a bubble necessary for innovation, or tell an investor which projects will last.

As anthropologist Clifford Geertz writes in the essay “Thick Description,” sometimes a new idea arrives in the intellectual landscape, and people try to use it to solve all problems in their fields.[6] They try applying it to everything. This burst of attention teaches us a lot about the idea and its limitations. Over time, we develop a narrower definition of it, which gives it long-term usefulness as a theory.

When enthusiasm drives rapid growth, ask what would sustain demand after the excitement fades. Popularity can bring investment without making an asset’s price, a product’s sales, or an idea’s influence durable.