Investment fund manager Mike Taylor looks at how booms start – and how to keep your head during them.

We must sit on our hands at times, when all our friends are making a fortune on Bitcoin, because gambling isn’t investing.

Bubble, bubble, toil and trouble! No, I’m not talking about witches and ghouls with cauldrons of frogs’ legs, deadly nightshade, children’s fingers, and the toenail of a Galapagos turtle.

I’m talking about investment bubbles – stocks and shares, the theory that what goes up must come down, and why investors create bubbles, despite every shred of logical evidence to the contrary.

If you’re getting investment tips from a taxi or Uber driver, then I’m afraid you probably are, literally, the last cab off the rank. But you won’t be alone.

How bubbles start

Interestingly, all bubbles start out with a genuine investment idea or business that’s often revolutionary in some way. However, as the price of the investment begins to rise and attracts more people, the price starts to move away from its fundamental value.

If the investment has enough ‘blue sky’, the bubble can keep growing bigger until investors start talking about a new paradigm. They use all sorts of reasons to justify why they expect the price to go significantly higher in the future.

Investors take comfort from the fact that someone else is already paying this price. Not even a cold dose of reality can stop greed if the price is going up; the fear of missing out becomes more powerful than the fear of losing.

Since the birth of the modern economy, many people have at times lost all sense of rational thought when it comes to investing. A term even exists to describe this: ‘irrational exuberance’.

The madness of men

Sir Isaac Newton, one of the smartest people who ever lived, made and then lost a fortune on the South Sea Bubble in 1720. Afterwards he apparently said, “I can calculate the movement of the stars, but not the madness of men.”

Yet today, despite all the modern literature on investment bubbles, and our unlimited access to information and technology that would have astonished Newton, we can’t resist the temptation to invest in what everyone else is investing in. That, ladies and gentleman, is greed, and I just don’t think it’s something we can eradicate from our DNA.

The year 1636 was the first recorded case of a modern investment bubble. It’s since been called the Tulip Craze. Over this time, tulips became so popular in Holland that some rare bulbs cost the same price as a house.

The story goes that the bubble burst when a sailor went into a grocer’s shop for some fish and potatoes, saw what he thought was an onion on the counter, and stole it. Later, the wealthy merchant caught up with the thief, only to find his prized tulip bulb had been fried and eaten at the local tavern.

Sometimes, when investors have been irrational, the smallest thing can trigger a price collapse. Once the selling starts, it can quickly become a tidal wave.

The end is never pretty

Unfortunately, when bubbles burst, the end is never pretty. They might climb the stairs but they sure go down in the lift.

Take the railroad boom, 1929 share market crash, 1987 share market crash, the dotcom bubble, and Bitcoin.

These booms all looked good at the time, but bubbles always end in tears and often affect the most vulnerable, least sophisticated investors, who get sucked in by the madness of the crowd near the end of the run.

But really, why do we keep doing this?

Well, the future is impossible to predict, so any outcome is theoretically possible. So, at the top, yes, we can persuade ourselves that it’s possible the price could keep going higher.

We all want to believe in the tooth fairy; it makes us feel good. But that doesn’t make her real.

When house prices have gone up year after year, we want to believe that trend will continue, but mathematically, logically, it can’t. Yet, just weeks ago, someone told me they’re buying Auckland property because they believe it doubles in value every seven to ten years, because that’s what it did over the previous period.

What to do

As investors, we must expect an uncertain future, control our emotions, and invest like an algorithm.

We must resist the urge to invest when there is nothing of investment grade. We must sit on our hands at times, when all our friends are making a fortune on Bitcoin, because gambling isn’t investing. And we must hold cash when everything is expensive.

The average volatility of a company in the Dow Jones is 50 per cent. Bear in mind these are some of the largest businesses in the world – so what hope does the average investor have?

The psychology of investing is something that even as a professional, I still grapple with daily. It’s hard, because some great ideas that we sell too early really do go on to invent sliced bread.

I finish with this conundrum: Investing is a beauty contest, but it’s not about who you think is the prettiest, it’s guessing who the judges will select as the prettiest – and then knowing when they will change their mind.

By Mike Taylor

First published 1 February 2018

The editorial below reflects the views of the editorial contributor only and content may be out of date. This article is sourced from a previous JUNO issue. JUNO’s content comes from sources that it considers accurate, but we do not guarantee that the content is accurate. Charts are visually indicative only. JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions.