Learning From Panics And Manias
Even though the future hasn’t been written, smart investors are wise to learn from the mistakes of the past. Not only because history is going to repeat itself, but because human behavior really hasn’t changed since the stone-age.
True investing wisdom is pretty much timeless. It doesn’t matter what new investing fad comes along — the same principles that led to safe investing hundreds of years ago, still hold true today.
When I first published this post almost a year ago, I was reminding myself not to chase impossible gains. The stock market had been on quite a tear at the time. Bitcoin ‘investing’ was getting pretty popular too. I was tempted to invest in assets with prices that made little sense.
Now, its a year later and the stock market is even higher than it was a year ago (despite rising interest rates).
With my portfolio reaching new highs almost every single day this week, I needed a little humility ‘reminder’.
So, I dug up a little timeless advice…
Greed & Fear
It has been said there’s 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 is often the main driver of this behavior, leading to stock market bubbles and excessive commodity speculation. Investors get greedy and seek out higher and higher returns. Prices rise to stratospheric valuations, and eventually (inevitably?) this leads to the bursting of financial bubbles.
Fear takes over, as panic selling set in. Prices are driven in the exact opposite direction at speeds many times that of the original manias.
Frequently the nest eggs of savers get crushed as a result. Fortunes get turned into pocket change. The dreams and hopes of a comfortable life (and easy retirement) are lost to the market’s senseless monetary destruction.
Such is the way of history’s manias and panics — Greed and fear drive the behavior that moves markets.
Is the market greedy or fearful today?
Investors Have Short Memories
Unfortunately, most investor’s memories are quite short. People forget past mistakes in less than a single generation. Time has a way of healing many wounds, and dreams of wealth 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 remember: Every 10 – 20 years it seems like a new bubble gets created and the cycle repeats itself all over again. It’s been 10 years since the last bubble burst.)
So are investors doomed to repeat history over and over again? Well, I try to keep a positive outlook. Some investors are going to get burned, that’s true. But not everybody.
My belief is that wise investors can take steps to insulate themselves from market disruption. With enough experience, wise investors can even learn to profit from the volatility.
A 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 future net worth.
If you’re looking for something a little less dry than Wikipedia, 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 try to prepare myself 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 here:
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. Avoid investments frequently funded with speculative 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 we 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 tulip bulbs. 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, index funds also have some problems (no investment is perfect or risk free). Broadly diversifying an investment portfolio like this still exposes investors to big swings in the economy. You could be buying into that index fund at bubble prices. Bubbles are still going to pop and recessions will still 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?
41 thoughts on “Learning From Panics And Manias”
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.
Thanks Cheesy! Great to hear your perspective on the tulips. We often think of the tulips as folly, but we forget what a wonderful impact it had on the Dutch economy over the years.
Great insight! 🙂
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.
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The 2008-2010 period was pretty fantastic. We also did very well in that same period!
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.
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.
Great to hear your different perspective on this Ms. FAF!
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.
I’ve seen some studies that say the U.S. economy only grows when credit is available. Thus when the economy is growing, consumer debt is constantly expanding. I find this troubling, but it does make a certain amount of sense.
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)
Completely agree DGI! I can’t predict a bubble any more than the next person, but I like to remind myself to “stay humble” when things are going uncommonly well.
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.
Yup, but the book is still great without the updates!
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!”
Good points Jack. I’m a big believer in index funds too, but one thing I think the FIRE community might be forgetting in its “groupthink” is that buying assets at any price is a bad idea.
Some index investors do this, and it worries me.
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.
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It’s true, nobody can predict the future. I try not to fall into that trap, but when I see irrational behavior I tend to get more cautious. Not saying I can always identify it, but you do get a feel for what’s realistic after awhile.
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!
Totally agree. I’ve never purchased anything on margin and it’s highly likely that I never will!
Regarding the latest bubble on something without cash flows are you referring to the new crypto currencies that are coming out?
Crypto currencies are a great example. Or speculating in gold. Baseball cards… whatever kinds of assets that don’t product cash flow.
“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!
I really enjoyed your post from Amsterdam. It was magical!
Panics and Manias are great! “It’s time to Buy when there’s blood in the streets”…..Rothschild
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.
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Great point TPM. For companies that were around in 2008/2009, I always look at how the company handled the recession and how management reacted. Some did better than others, and it’s a great time period to study!
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…
One thing I’ve noticed is everyone’s focus is currently on making more, not keeping capital safe from destruction. During downturns or recessions this mindset shifts to safety… the shift from greed to fear.
I definitely see plenty of greed going around, but not a lot of fear.
That was a great article ! I agree Manias, Panics and crashes is a great read.
I have read a bit about past bubbles … the Tulip one seems to be quite famous … I think people are nervous now seeing they remember the last crash … but for many others the dot.com bubble or 97 Asian crisis might be fading …. it is always good to diversify investments with a spectrum of investments such as you mention in other posts … as for now we live like kings over here … Michael CPO, From the Far Side of the Planet
Yes, it *does* feel like I’m living like a king. It’s rather unnerving of course. I *shouldn’t* be making 20% in the span of only couple of weeks!
I benefited from the last bubble (housing) because I had assets I needed to invest and the markets were fearful (and I was and am relatively young). I think the cash flow / greater fool theory is very appropriate and usually it also comes with a strong sense of FOMO. You will also usually see a flood of shady individuals trying to profit off a particular market too – usually “teaching” you how you can benefit. You see that right now with cryptocurrency.
I subscribe to the “hit singles” philosophy. I don’t need home runs, triples, or even doubles – just avoid striking out and consistently hit my singles until the cows come home. You can avoid strikeouts if you avoid bubbles. 🙂
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Great comment Jim. During the housing bubble of 2008 everyone and their grandma was trying to make money off of real estate. It felt really shady. So you make a great point.
I also agree with the strategy of ‘hitting singles’. My life is a series of ‘singles’ lined-up one after another. Yes, a couple times I got lucky and got more than a single… but I was only trying for a single.
And everyone became a real estate agent! Just like everyone became a day trader in the dot com bubble… people chase the fad realizing all the money has been made before it becomes a fad.
Singles make a great long career and that’s what matters, not the home runs.
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The book looks really interesting – I think I’ll take a look at it.
Out of curiosity, when you advise people not to buy a home until they can pay for the mortgage outright, do you think they should rent an apartment/home until they can afford that sum? I must say that at my stage of the game, I’m torn between renting and owning.
On one hand, I don’t like the thought of throwing my money down a metaphorical drain each month while renting. On the other, I don’t want to jump into home-ownership before I’m financially ready for it. Thoughts?
In general, I recommend avoiding debt if you can. Those who save up for a down payment only to buy the most expensive house they can, do themselves a huge disservice.
It’s like taking one step forward into a positive net worth (with all the wonderful benefits that entails), and then taking 5 steps backwards into a negative net worth.
Asinine is the word that comes to mind.
That’s very true. ESIMoney just mentioned “lifestyle creep” in one of his recent posts. Your example is indicative of the lifestyle creep and should be fought tooth and nail if possible…especially after discussing bubble bursts!
Thanks Mr. Tako!
I love the history, thanks for posting those. I didn’t know about some of those past bubbles. Being that people are people and emotions are emotions, I think, for me at least, the safest way to invest is to “set it and forget it”. With index funds of course. You have a great analytical mind and are able to research and pick winning stocks, and you also have the ability to think pragmatically and control your emotions. Most people don’t. Therefore index funds and set it/forget it is probably a good strategy for most.
Gosh thanks Accidental FIRE! You’re too kind! Index funds have been one of the main ways that our family has built wealth too! “Set it and forget it” is a great strategy!
Very interesting post. Thanks Mr. Tako! I really the history of the stock market and its bubbles. I never went so far back in time, but the history of the 29 crash is really interesting. As you said, the biggest issue is to invest with debt. This is great when the market is in bull, but as soon as it turns in bear, it gets bad. It should be avoided all the time.
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