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:
Tulip mania (top 1637)
South Sea Company (1720)
Railway Mania (1840s)
Encilhamento (“Mounting”) (1886–1892)
Roaring Twenties stock-market bubble (c. 1922–1929)
Japanese asset price bubble (1980s)
1997 Asian financial crisis (1997)
Dot-com bubble (1995–2000)
- US Housing Bubble (1997-2008)
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.
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.
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:
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.
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.
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.
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?