How to make (and lose) money from stockmarket bubbles

It can be very tempting to buy into a bubble when all around you fellow investors seem to be making easy money. But as a very interesting article today in the Daily Telegraph demonstrates, market timing is everything.

In stockmarket terms, “bubbles” are usually defined as a period when stock prices run ahead of the real valuation of underlying assets, or when stock prices are driven higher than their valuation might justify.

As the Telegraph article illustrates, many people were seduced into buying into the South Sea Company after it was set up in 1711.

The company was promised a monopoly on trade with Spanish South American companies by the British government in return for taking on debt incurred in the War of Spanish Succession.

Intitially, investors made good money. Indeed, Sir Isaac Newton invested early and sold out into profit. But he then made the mistake of buying back into the company at a later date.

The shares were on a roll, rising  from £128 in January 1720 to £1050 by June the same year. Who would want to stand by and miss out on the chance to make a fortune so quickly?

But the bubble burst shortly afterwards, bankrupting many investors. Newton himself was said to have lost £20,000, the equivalent of around £3 million in today’s terms.

That one of history’s smartest men could have been so badly burned by the volatility of the stockmarket is a salutory lesson. The psychology of humans means that we find it very hard to stay level-headed during such frenzies, and those who stand on the sidelines fear they are missing out on a one-off opportunity to make their fortune.

Also, investors are prone to suffer from attachment bias, in other words, they struggle to imagine a scenario which is radically different from the current status quo. A good example is house prices. Residential property in this country is overpriced relative to wages and mortgage affordability, but if you ask anyone what they think their house is worth they are unlikely to quote you a figure 20 to 30% less than the current asking prices on their street.

Knowing when to invest is best learned early on
Market timing can be problematic

Similarly, if you have owned a share which has hit a high and then fallen back significantly, it can be difficult to acknowledge that you are unlikely to see the stock reach that price again in the short to medium term, if ever. This requires you to reassess your data and to accept that you have made a mistake.

So attachment bias prevents you from making an impartial decision and means people tend to discount evidence which contracts their opinion. It is one of the contributory factors to creating a bubble, and explains why the sceptics are often sidelined or ignored even when the bubble looks ready to pop.

Much of investing is about managing one’s own psychology and having the courage to question the behaviour of the crowd. It is much harder to do than it sounds, but is a lesson best learned early on.

You can read the full Daily Telegraph article here.

Marianne Curphey May 2014