I believe it’s valuable to understand the past when we want to move forward. With investing, it’s rare to see something that hasn’t already happened. Sure, there might be differences that make a specific situation unique, but there’s going to be more similarities than differences. That’s because at the end of the day, investing is all about behaviour, numbers, and patterns.

There’s two main ways to learn something, either by experiencing it first hand (experiencing something yourself), or second hand (such as reading, watching, or hearing about someone else’s experience). With investing it’s a lot friendlier on your bank account to learn through other people’s experiences.

It’s not the intention of any investor to lose money, but it happens. Bubbles happen quite often on an individual stock level, and once a decade or so on a market level. Everyone who is reading this has already experienced a number of them, or will in their lifetime. So I think it’s important to understand them.

What is a Bubble?

Stock markets function on a simple principle: supply and demand. Although it’s simple, sometimes it can get off balanced.

When there’s a lot of excitement around a company, or when the markets have steadily gone up over a long period of time, more people are likely to participate in markets. This excitement increases demand, and typically leads to increases in stock prices.

When stock prices increase because of excitement or prolonged periods of positive returns, prices rarely accurately represent a companies true value. When prices abandon logic, it gets difficult to determine how high prices can go, and sometimes prices can get way out of hand.

Take GameStop for example, it’s new 52 week high is $483, giving it a market valuation of over $33 billion, when fundamentally it should be valued around $2 billion. So if the stock price is $483 or $1,000, it doesn’t really matter because it stopped making sense ages ago.

A bubble is a inflated company stock price. If you’ve ever blown a bubble, you know if you blow it big enough, it will pop.

Before we get into it, a lot of this article is inspired by one of my favourite investing books: A Random Walk Down Wall Street, by Burton G. Malkiel. If you enjoy this article, and want to learn more, I’d recommend you give it a read. You could even borrow it from me, as long as you don’t mind my highlights and notes.

Looking Back

Let’s take a look at some of the bubbles throughout history. All of these are quick summaries, to learn more about any of these bubbles I’d encourage you to do extra research, because they all are fascinating.

1637 — Tulipmania

One of the first bubbles on record, and maybe the most bizarre, is the tulip-bulb bubble of Holland.

The story starts in 1593, when tulips were first introduced to Holland from Turkey. With most new things, there was a lot of excitement around the flowers, people wanted them. At first owning tulips was a status symbol for the rich and wealthy. Over time they became more affordable and more and more people were getting their hands on them.

The real craze started happening about 40 years later, after the tulips were infected by a virus, which caused the petals to develop contrasting designs. The more designs, the rarer and more valuable the flower. Much, much more valuable.

https://www.wealthstrategies.in/tulip-mania-how-an-entire-nation-went-nuts-over-tulip-flower-bulbs/

It got so out of hand that during the uprise and peak, people were taking out loans, selling their possessions, even trading their lands and houses, just to buy tulip-bulbs. Eventually prices got so high that people couldn’t refuse to sell, and others did to, until everyone was.

Then, in almost no time at all, tulip-bulbs were virtually worthless, losing 99% of their value. Something that people were once trading their land for, was now the same price as an onion.

1720 — The South Sea Bubble

The South Sea Company (SSC) was given exclusive rights by the British Government to the seas of South America. A lot of British citizens saw this as a deal of a lifetime, and anticipated unlimited riches and treasure.

When the SSC first offered shares in the company, they were swept up almost instantly. So they offered more, and then more. Each time people bought them up quicker and quicker and were willing to pay more and more.

The SSC was viewed as a company that couldn’t fail. At its peak, it’s estimated it was valued at over $4,000,000,000,000 (four trillion dollars) in today’s money — which would be the equivalent of combining Apple and Amazon.

The idea was too successful, there were more people looking to buy shares than there were shares to be sold. People started coming up with ideas for companies so people could start investing in them, and people couldn’t wait to throw their money at them.

Most of the ideas were absurd and there’s even reports of people ‘disappearing’ right after collecting a bunch of money from investors. As you can imagine, most of proposed business ideas failed within a week or two, and the SSC followed soon after.

The SSC wasn’t as prosperous as what was originally hoped (surprise, surprise) and once company officials figured it out there was a massive sell off. As priced dropped, retail investors panicked and sold too. And in a matter of months, all of the wealth that was created in the SSC was gone.

Even Sir Isaac Newton was caught up in the excitement and reportedly lost what would have been millions of dollars today. He was quoted saying “I can calculate the motions of heavenly bodies, but not the madness of people.”

1929 — The Great Depression

The 1920’s were a very prosperous period in America, often referred to as The Roaring 20’s. In the 18 months leading up to the crash, growth matched the growth for the previous five years.

In some cases companies increased by over 400% in the 18 months leading up to the crash. People perceived the economy as a well oiled machine that was unstoppable.

When market news is frequently in the media, it’s a dangerous time to jump in. During the market collapse, some fund managers built up large stockpiles of certain stocks, and when retail investors looked to purchase, the prices soared and the managers sold out.

The head of America’s second largest bank at the time, sold some of his bank shares at the peak, and then shorted the banks shares on the way down. Reportedly making millions in each direction. Something that would all be illegal today.

To me it sounds like an entire nation was participating in a pump and dump (hype up a company in order to increase the price, and sell for a profit). By the end of the decline in 1932, most blue-chip stocks declined by over 95% from their pre-depression highs.

To quote A Random Walk Down Wall Street, “It was irrational speculative enthusiasm that drove the prices of these funds far above the value at which their individual security holdings could be purchased.”

1962 — Tronics Boom

The end of the 50’s and beginning of the 60’s saw an increased demand for a new technology: electronics. Companies like IBM and Texas Instruments saw huge growth as demand for their products, and hope for their potential grew. And those companies weren’t alone.

The period from 1959 to 1962 saw more new companies going public than ever before. Drawing comparisons to the South Sea Company period.

The craziest part of this time is that companies were changing the title of their company to sound more tech, even if their product in no way reflected the electronics movement of the time. Adding ‘tech’, ‘tron’ or anything else tech-y instantly increased the ‘value’ of the company, and investors jumped at the chance to invest.

When these new companies went public there was a huge demand and prices jumped. As the excitement built they hit record highs in 1961. When the bubble finally popped and the companies hit bottom in 1962, the stocks traded for a small fraction of their previous values.

1973 — The Nifty Fifty

The 70’s took a different approach, out of speculative investments, and into blue-chip stocks. Household names, many of which are still around today: Disney, IBM, McDonalds, and Xerox to name a few. In total there was about 50 stocks, hence the ‘nifty fifty’ nickname.

The logic was that these companies were so good, and so solid, that it didn’t really matter what you bought them at. They would last the test of time, they would only go up, and their price would be justified.

Throughout the climb many of these stocks traded for 80 or 90 times their earnings multiple. At a point, the stocks became viewed as being priced too high, and shares were sold. A snowball effect pursued and eventually those stocks were trading with earnings multiples below 20. Again, losing much of their value.

2000 — The Dot Com Bubble

The internet created a perfect storm for a market bubble: it combined a brand new technology with a brand new way to trade and do business. The expectations were out of this world, so we once again saw people willing to buy at ridiculous prices, thinking the growth would go on forever.

Just like in the 60’s, there was a bunch of companies that altered their company name to give off the impression that they were involved in internet technologies, and everyone wanted a piece.

Traditionally the ratio of buy vs sell stocks according to analysts is 10:1, but during the dot com bubble it was 100:1. Everyone was pumping up stocks, buying at whatever prices, and people were getting the impression investing was easy and fundamentals didn’t matter.

“The bubble was aided and abetted by the media, which turned us into a nation of traders.” — Burton G. Malkiel, A Random Walk Down Wall Street.

At the peak of the bubble, people started to sell their shares. Maybe the profits were too good to pass up, or people started to realize the degree of overvaluation of the market. But either way, selling usually leads to more selling, then panicked selling.

Most of the speculative companies went on to be worthless. Even internet giants lost big. Amazon lost 98.7%, Cisco lost 86.5, Nortel lost 99.7%, Yahoo.com lost 96.4%, to name a few.

“The Internet spawned the largest creation and largest destruction of stock market wealth of all time.” — Burton G. Malkiel, A Random Walk Down Wall Street.

2008 — Financial Crisis

The 2008 financial crisis began with the US housing market, but caused a world wide recession. Governments and lenders relaxed the qualifications for someone being able to purchase a home. People were able to qualify with $0 down, and no verification of their income, job, or assets.

There was something referred to as NINJA Loans (no income, no job, no assets). This lead to many Americans buying homes they couldn’t afford, and with anyone being able to buy a house prices skyrocketed. Prices were increasing so rapidly that people would buy a house just to sell it at a future date for profit.

To make matters worse, lenders weren’t holding on to their mortgage deals, they were selling them to investing bankers who would bundle them up with other mortgages, slap an excellent rating on it, and offer them as an investment option.

Investors were under the impression they were investing in solid mortgages, but that wasn’t the case. There were even more complex ways to bet or invest on the mortgages, but to be as simple as possible, it was all garbage. People were throwing their life savings at garbage covered in Christmas wrapping paper.

As the housing market started to cool, many Americans were stuck with mortgages that were higher than their houses were actually worth. When home owners started defaulting on their loans, the mortgage bonds crumbled.

Banks started declaring bankruptcy, and that caused investors to panic as they lost confidence in the markets. The US market is the largest in the world, and whatever happens with it, impacts the world economy.

It took almost five years for the American stock market to recover from the 2008 financial crisis.

Looking Forward

With all of the bubbles we looked at, there’s common factors in each. No matter what the underlying asset was, there was a ton of excitement around it that caused prices to increase rapidly. In each case the prices defied logic and reason. And in each case we saw massive sell offs that wiped out all of the value that was created during the bubble, and then some in most cases.

During bubbles, it can be difficult to see past all of the money being made and see fundamentals. But looking back it’s always obvious. Bubbles can be focused or market. A focused bubble could be on a specific company or industry. Whereas a market bubble would impact the entire market.

Focused Bubbles

Focused bubbles are more volatile and more risky than market bubbles. It comes back to the saying don’t put all of your eggs in one basket.

Focused bubbles happen quite often, more often than someone outside investing would imagine. In the past week or so almost everyone has heard about GameStop. The example I use more than anything else, is Tilray.

Tilray was the first cannabis company listed on the NASDAQ, and shortly after being listed it jumped up to $300 per share in September 2018, only to downtrend from there to a low of $2.43 in early 2020. Losing over 99% of it’s value during that time.

When you’re investing in individual companies, there’s increased risk. When you’re speculating on companies during bubbles, that risk increases exponentially, it becomes gambling.

In A Random Walk Down Wall Street, Malkiel talks about the castle-in-the-air theory. The theory, originally described by John Maynard Keynes, suggests that using logic in the markets is too much work, and an alternative method is to try to predict what the greater crowd of investors is likely to do. If you can beat them to the punch, you can make money once mass buying begins.

The castle-in-the-air theory relies on less educated investors following the crowd, as we’ve seen in every bubble example, and relies on there being a greater fool. Essentially, no matter what you pay for something, you can always make money, as long as someone else is willing to buy it from you for a greater price than you paid. It’s very simple, and seems avoidable, yet people always get dragged into it.

Look at GameStop, our most recent bubble. I believe more people paid attention to stock market news in the past two weeks than ever before.

When you see people making a bunch of money from a stock, people get the feeling of FOMO (Fear Of Missing Out). Instead of looking at it logically, people throw money at it, usually buying way to high, and losing a majority of their investment, if not everything.

Most focused bubbles negatively impact the little guys more than anyone. The people who are hoping to get rich quick, are the people who in most cases have the most to lose. If you’re hearing about a stock through the media, it’s typically already too late. If it seems like it’s too good to be true, it usually is.

Market Bubbles

Market bubbles on the other hand are generally unavoidable. The truth is, they are a normal part of stock markets. Stock markets are made up of companies. All companies go through different phases of business cycles, as seen below. Just as companies go through times of hardship and growth, so do markets.

Business cycles in reality don’t look as clean as they do in theory. The S&P 500 is made up of 500 American companies, so it’s a great representation of how the American stock market performs.

Going back to the 1920’s, I’ve highlighted the market bubbles that we’ve talked about above, and some others.

Bubbles, market crashes, or corrections happen about once a decade or so for the American stock market. The thing that makes market bubbles different than focused bubbles, is the likelihood of recovery and expansion.

In focused bubbles, a majority of companies caught up in the bubbles don’t survive, or if they do, don’t go back to their all time highs. When a market gets caught up in a bubble, time and time again, we see a recovery and expansion from the pre-crash highs.

The areas identified as bubbles are few and far between. Even though the drops are significant, markets recover and then grow, creating new wealth for investors.

How to Survive a Market Bubbles

Bubbles are unavoidable. Throughout our lives we have experienced bubbles and will experience some more moving forward. But don’t worry, it really doesn’t have to seem like a negative thing.

If you’re a young investor, or if you have a long time horizon for your investments, market bubbles offer a good buying opportunity. There’s an old saying buy low, sell high. But most people are more keen to buy when prices are high (because of excitement) and sell when prices drop (out of fear).

When markets drop, it’s like stock prices go on sale. We spend a lot of time in our day to day lives looking for deals, digging through our emails or flyers for coupons, so why not do the same with our investments? When markets drop the best thing someone can do is to continue making their regular contributions and stick to their plan.

It might even be a good idea to consider making a lump sum contribution, or changing your asset allocation to capture more upside.

If time isn’t on your side as an investor, the best thing you can do is make sure your risk tolerance and asset allocation is up to date. Risk tolerance and your time horizon will help determine your asset allocation.

The nearer you are to having to withdraw funds, the more conservative you want to be. That way, if the market does drop, it isn’t truly reflected in your performance. You portfolio will likely still drop, yes, but in a way that won’t be disastrous to your goals.

In either case, it’s important to have at least a basic idea of how your money is being invested. A little bit of understanding goes a long way to keep fear and panic at bay. Ensure your investments are diversified, and if you have an Advisor, lean on them if you have concerns or questions.

The worst thing people can do, is what most people gut instinct tells them, is sell. In every bubble on our S&P 500 chart, the market recovers to the previous high, and then continues to grow. If someone sells during a market crash, they lock in the value of their account at that time. And if they sell during a market crash, they might be hesitant to ever invest again.

Imagine if someone pulled their money out during the 1987 crash and never invested again. Based on the S&P 500 performance, every $1 in 1987 would now be worth $16.

It doesn’t sound like much, but if they had $100,000 in 1987, it’d be worth about $1,600,000 today. If that money was pulled out and put into a ‘high interest’ saving account, earning 1% a year, that $100,000 would only be about $138,000. A costly $1.46 million mistake.

Finally, it can be tempting, but do your best to avoid being drawn into a bubble. If you’re hearing about a hot stock in the media, it’s too late, and that’s okay. Most retail investors get burned on things like that.

For every one success story that comes out of speculative investments, there’s hundreds or thousands of fails. GameStop is an incredible story, but in the existence of of the WallStreetBets thread, I would bet every company that’s ever been listed has been discussed on there. If you always followed the investment advice of others, you would have been bankrupt long ago.