Learning From Panics And Manias


It has been said that there is nothing new in the world of investing.  History is filled with interesting financial ‘events’ — from outright theft and wild speculation, to loose lending and direct government manipulation.  Markets really have seen it all.

Greed was frequently the main driver of this behavior, eventually leading to giant stock market bubbles and excessive commodity speculation.  Prices would get driven to stratospheric valuations, and eventually (inevitably?) leading to the bursting of financial bubbles.

Fear would then take over, as panic selling set in.  Prices were driven in the exact opposite direction, at speeds many times that of the original manias.

Frequently the nest egg of many careful savers got crushed as a result.  Their dreams and hopes of a comfortable life (and easy retirement) were lost to the market’s senseless monetary destruction.

Such is the way of history’s manias and panics.

 

Investors Have Short Memories

Unfortunately for most investor’s, our memories are short.  People forget past mistakes in less than a single generation.  Time has a way of healing many wounds, and dreams have a way of helping us forget past missteps.

Some investors are even unfortunate enough to get burned by multiple bubbles in a single lifetime.

(Something to keep in mind:  It seems like every 10 – 20 years a new bubble gets created and the cycle repeats itself all over again.)

So are investors doomed to repeat history over and over again?  Or, is it finally “different this time”?

While some burned investors are pessimistic, I try to keep a positive outlook on life.  I don’t believe investors need to repeat the mistakes of the past over and over.  My belief is that careful investors can take steps to insulate themselves from market disruption, and eventually even profit from it.

For investors (like myself) that live off income derived from our assets, careful cultivation of our investing farm becomes doubly important.

 

A Long History of Panics And Manias

In the beginning, every mania starts with someone making incredible amounts of money.  Greed drives other investors to join the party, driving prices ever higher.

In the end, the bubble inevitably pops and investors get hurt.  History is absolutely littered with market events that created and destroyed the fortunes (and lives) of countless investors.

Rather than ignoring history, I believe every investor should take the time to have a basic understanding of the world’s Manias and Panics.

Here’s a few of the more well documented market Bubbles in history, with linkage to the appropriate Wikipedia discourse:

Take a few hours of your day to read about these fascinating bubbles… it’s actually worth it.  What you learn might just save you millions in your future net worth.

The Dutch created one of the first modern economies in the world, and were innovators of a great many modern financial concepts. Isn’t it ironic they’re also famous for one of the earliest speculative bubbles in recorded history — Tulip Mania!

If you’re looking for something a little less dry than a Wikipedia page, I recommend reading Manias, Panics and Crashes: A History of Financial Crises (Sixth Edition).  It’s one of those classic investing tomes that’s been updated many times.  It also includes a recent treatise on Lehman Brothers and the U.S. Housing Bubble.

manias and panics
Manias, Panics and Crashes tells the economic story of history’s most interesting economic bubbles.  It’s worth reading!

 

Lessons Learned

While I can’t predict when the next bubble is going to pop, I do my best to prepare instead.  Over the years, I’ve compiled a number of lessons from my experience with market bubbles and my own study into the history of these events.  I’ve attempted to capture some of these lessons learned:

Debt

Probably the biggest contributor to the formation of history’s market bubbles has to be access to easy credit.  Historically, there’s dozens of stories where low interest rates lead to excessive borrowing and speculation in capital markets.  It all ends in tears.

The lesson learned to isolate oneself from inevitable disasters, is to avoid investing with debt.  I personally avoid buying on margin, and never use debt to purchase volatile assets like stocks.

While investing in certain assets like real estate usually requires debt, this doesn’t mean the rules don’t apply.  We could literally be in the middle of another real estate bubble right now.  Who knows!  Investors should minimize their leverage in such investments to less than 70% of the asset value.

For individuals looking to buy a home, I recommend NOT purchasing that home until you have sufficient assets to pay off the mortgage outright.  In my view, those assets can and should be invested in higher earning assets, like equities.

 

Imitation

Unfortunately, humans (being the big dumb apes that they are) tend mimic one another.  One investor finds success in investing in tulips, inevitably others will follow.

Back in the 1990’s, Warren Buffet gave a talk at Notre Dame that I believe illustrates the great perils of investing imitation succinctly:

During the Notre Dame appearance, he displayed a list of 37 defunct investment-banking firms. “Every one of these has disappeared,” he said. “This happened while the volume of the New York Stock Exchange multiplied fifteenfold. All these companies had people with high IQs working for them, (people) who worked ungodly hard and had intense desires for success and money. They all thought they would be leaders on Wall Street.”

Gathering steam, he pressed his point: “You think about that. How could they get a result like that? These were bright people; they had their own money in their businesses. I’ll tell you how they did it: mindless imitation of their peers. I don’t get great ideas talking to people. I never talk to brokers or analysts. You have to think about things yourself. ”

That says it all right there — even in healthy markets smart people can fail.  “Group-think” is not healthy for long term investing returns.  There is simply no substitute for thinking for yourself.  History tells us to avoid following other investors into overpriced assets….especially those made by “authority” figures.

The personal finance community exhibits a significant amount of this “mindless imitation”, and it worries me.  I personally believe individuals in the community would be better served doing a little “thinking for themselves” instead of mimicking the investments of the community authority figures.

 

Diversification

If you read into the history of bubbles, inevitably you’ll encounter stories about investors who “lost it all” investing in railroad shares, real estate, or event tulips.  While these are often sad, tragic stories, the lesson here is clear — Don’t invest it all in one place, no matter how good the expected returns.  Spread your money around a little.

While diversification can be taken too far, it also solves a lot of investing problems .  Imagine you’re invested 100% into a S&P 500 index fund.  Despite only making one investment, your investments are highly diversified.

Now imagine that during the time you hold this fund, the oil industry tanks because everyone starts buying electric cars. (Not that far-fetched, right?)  It’s likely that electric car companies would inevitably find themselves outperforming within that very same index.

This yin and yang balance “shields” investors from bad companies or declining industries by exposing the investor to all parts of the economy.  It’s a huge advantage for individuals who don’t have the time or inclination to make individual investments.  Diversification at low costs is one of the best reasons to own index funds.

That said, no investment is perfect or risk free.  Broadly diversifying an investment portfolio like this still exposes investors to big swings in the economy.  Bubbles are still going to pop and recessions are still going to hurt.

 

Lack of Cash Flow

One of the biggest mistakes (I think) investors have made throughout history is not investing in assets with real cash flows.  That is, they purchase investments that don’t pay dividends or interest.  Instead of investing for future cash flows from that asset, investors end up relying on the “greater fool theory” to realize profits — that is a “fool” purchases at one price who must then find a “greater fool” who will purchase at a higher price.

cash
Innovation and growth are one thing, but consistent payments of cold hard cash help investors determine reasonable valuations for investments.

Without real cash flows, the market prices of many assets can become completely unhinged.  This is one of the reasons why I invest mainly in dividend paying investments.  I always ask myself, “Where does your money come from?

One such example of price mania: Back during the Tulip Mania days, individual tulip bulbs could sell for more than ten times the annual salary of a skilled craftsman.

All that for a single flower!  That’s incredibly expensive!  Would you work and save for ten years to buy a single flower that had no regular cash flows?  From our perspective today, this seems incredibly speculative…

What about you?  Do you have any lessons learned from history’s Bubbles, Manias, and Panics?

[Image Credit: Flickr1, Flickr2]

15 thoughts on “Learning From Panics And Manias

  • August 23, 2017 at 4:44 AM
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    Nice and interesting collection of mania’s. Those crazy Dutch, eh? But those tulips got us a long way though.
    As to leverage/debt for real estate, we realize there will be another crisis coming and are currently careful in how much debt we will take on to expand the RE side of our investments. Have not figured out yet how much that would be.
    I can definitely see the perk of Dividend investing here too, to bridge your way across the crisis itself in terms of cash.

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  • August 23, 2017 at 4:50 AM
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    I’ll have to check out the book recommendation (Manias, Panics and Crashes), it looks very interesting!

    I am in my late 20s, so while I remember some financial stress in 2008-2010 with my parents, I was in college and oblivious to the market and the world. I knew nothing about investing and didn’t pay attention to the stock market. My husband, on the other hand, graduated college and started investing in his employer 403(b) in 2006. He promptly forgot about the account and invested 5% (+5% employer match) throughout the crash.

    When we got married and were digging into our accounts, I was shocked to see the returns on the investments he made during 2008-2010. They had skyrocketed! It was certainly a wake up call that showed us how profitable investing can be in a market downturn.

    Based on that knowledge and our desire for financial security, we have worked to manage our money wisely so that we are not only ok during the next bear market, but we are also in a position to continue to invest.
    Mrs. Adventure Rich recently posted…Adventure Challenge #4: Get Sandy

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  • August 23, 2017 at 5:10 AM
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    Thanks for the great analysis, Mr. Tako! Looking at the emerging markets, especially in Asia, I have seen:
    1. Access to credit
    Access to credit is one of the main concerns and a key hurdle to growth for businesses in Asia, such as those in China and Vietnam. Business owners usually have to resort to family, friends, and connections to gain access to capital for their investment.

    2. Diversification
    Diversification can mitigate risks, but diversifying into the wrong sector can burn a business to the ground. Prior to the 2008 financial crisis, many enterprises in Vietnam (i.e. seafood, dairy) expanded into real estate and went bankrupt because of the housing bubble burst. They chose to dip their toe into a seemingly lucrative area that they were not familiar with and highly leveraged themselves to grow.

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  • August 23, 2017 at 6:20 AM
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    Nice post. I can’t believe we humans have been undergoing bubbles/crashes for so long. Will we ever learn! I suppose not as long as we continue to be greedy and value material possessions.

    I am a big fan of the S and P index fund, though I still have some assets in REITs and large cap funds.

    Access to credit is important, as FAF states above, the problem is when it is too readily available.

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  • August 23, 2017 at 6:29 AM
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    Hi Mr Tako,

    Thank you for being prudent in the current environment. One of the reasons I enjoy your blog, is because I have reached similar conclusions on the following topic:

    “The personal finance community exhibits a significant amount of this “mindless imitation”, and it worries me. I personally believe individuals in the community would be better served doing a little “thinking for themselves” instead of mimicking the investments of the community authority figures.”

    Also, I enjoyed the trip down memory lane about the historical manias and panics. I had not heard about the “Encilhamento” before.

    Plenty of people today are excited about growth names, but they forget that a growth company does not necessarily mean better returns than others. On the other hand however, plenty of people have been calling “bubble” for at least five years ( for the past decade for example I routinely have heard that dividend stocks are in a bubble)

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  • August 23, 2017 at 7:42 AM
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    Love it!
    Those who don’t know history – repeat it – and then are surprised!
    I didn’t know there was an update on the classic mania text. Cool.

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  • August 23, 2017 at 9:09 AM
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    The group think effect is something that scares me a lot. The FIRE community adores low cost index funds. I like the concept, agree with the analysis, and am invested myself. But is this just groupthink because the greats think so or is it groupthink because “COME ON PEOPLE! Great VALUE for the money!”

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  • August 23, 2017 at 9:18 AM
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    Nice analysis. Years ago the dot com bust bit me. The only problem, it’s very hard to determine if your in one of these bubbles until it bursts. They can also last a long time and even after bustbe higher then the first point you suspected it. Take Greenspan’s Irrational Exuberance speech. It took nearly half a decade for the markets to close lower then that day.
    FullTimeFinance recently posted…Financial Diligence and Waves

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  • August 23, 2017 at 10:47 AM
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    Great analysis. Debt can greatly restrict you in bad times. If you have a huge amount of debt and the interest rate is going up, you’re screwed. You’re also screwed if you trade on margin and the market is going for a nose dive. I’ve known a few people that got burned very very badly during the financial crisis and dot bubble because they were trading on margin. Just don’t do it!

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  • August 23, 2017 at 11:34 AM
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    Mr. Tako,

    Regarding the latest bubble on something without cash flows are you referring to the new crypto currencies that are coming out?

    -Mike

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  • August 23, 2017 at 12:45 PM
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    “Biggest contributor to the formation of history’s market bubbles has to be access to easy credit.”

    Completely agree with you. The biggest way to trick people into spending tons of money is to make them believe they can afford (AND deserve) to live a life outside their means. That’s why I believe bubbles are always going to happen because there are WAY too many people out there who would easily fall for this. It’s too seductive for them not to.

    Funny that you should mention the dutch tulip craze…I’m in Amsterdam right now!

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  • August 23, 2017 at 1:45 PM
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    Panics and Manias are great! “It’s time to Buy when there’s blood in the streets”…..Rothschild

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  • August 24, 2017 at 10:29 AM
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    Its always great to understand your downside risk. Like you suggested, its always a great place to invest in companies that are gushing cash. I always take look back to 2008/2009 to see how the cash flow grew or disintegrated in the companies I select for long term holdings. This helps me sleep well at night.
    Turning Point Money recently posted…Learn From My Mistake – Don’t Sell a Stock Early

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  • August 25, 2017 at 8:27 AM
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    I’ve been lucky enough to get through the last 2 crashes without too much trouble. What I learn was to avoid investing with debt – no margin loans! Also keep investing through those crashes. If your investment didn’t completely go bankrupted, then it will probably recover after the crash.
    It’s going to be interesting how new investors handle the next crash. They’ve been enjoying the good time for so long and their perceived risk tolerance is probably way higher than they can handle in real life. Good luck to everyone…

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  • August 26, 2017 at 8:29 AM
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    That was a great article ! I agree Manias, Panics and crashes is a great read.

    Reply

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