Anyone pursuing financial independence through a passive investing strategy knows they're going to be in the market for the long haul, and that means they're going to need to weather at least one - maybe a few - market bubbles or stock market crashes in their lifetime.
Since nobody knows when a bubble will burst and cause a market crash, or when that crash will bottom out once it happens, the only reliable strategy is to stay invested right the way through. In theory it sounds easy and historical data backs this approach, but in practice it could be a lot harder. In this article I've identified some basic principles to help you avoid getting caught in the mania, and to increase your chances of making it through to the other side.
It sucks to think about, but this is the reality of the stock market and it will go through its bull and bear cycles whether we like it or not.
Whenever people feel there is a bubble being formed in the market they often bring up the term "Tulip Mania" in reference to the well-known event where tulips once rose drastically in price - despite having little to no intrinsic value - before crashing back down, causing huge fortunes to be made and lost almost overnight.
Being an avid investor and someone who just loves digging into historical details I realised that despite my familiarity and recognition of the words "Tulip Mania" I didn't actually know a whole lot about the story behind it - nor do I actually know that much about market bubbles in general.
"Those who cannot remember the past are condemned to repeat it" - George Santayana
Most of us will be somewhat familiar with the above quote in some shape or form and if we're to heed its warning the best thing to do is to educate ourselves a little on market bubbles that have happened in the past in order to prepare ourselves for those that will happen in the future.
The story of Tulip Mania
During the late 1500's to late 1600's Holland experienced an era of great military, science, art and economic prosperity known as the Dutch Golden Age.
In fact, the world's first official stock exchange - the Amsterdam Stock Exchange - and the world's first formally listed public company - the Dutch East India Company.- were both from Holland.
At some point in the mid to late 1500's tulips began appearing in Europe and were distributed around to various places, one of those being Amsterdam, where their popularity started to grow and people began to cultivate them. This was in part thanks to the tulip's ability to survive in harsher conditions than other flowers that the Dutch were accustomed to seeing.
Soon the tulip came to be regarded as a status symbol thanks to its unique appearance, and this combined with the economic rise of the Dutch economy soon turned the flower into a highly sought after luxury. This would lead tulip growers to grow different varieties and the types that had the most intricate colours and flame-like streaks would be most highly sought after thanks to their exotic looks.
Since tulips can take many years to cultivate - 7 to 12 years from a seed - the time it took to grow the most sought after varieties could take quite some time.
While this was happening the flower grew in popularity and the price to buy seeds or bulbs of the right variety rose steadily as the demand increased. By 1634 the tulip market started to see speculators - some of whom were from other nations such as France - who would buy and sell seeds and bulbs in hopes of turning a profit.
Eventually a futures market was created and it became possible for the speculators and growers to trade contracts that would give the holder the right to buy bulbs at the end of the season.
Over the next few years the price of tulips rose rapidly thanks to the speculators trading these futures contracts - where a single contract could be exchanged dozens of times within a single day or before the bulbs had even left the ground - with some speculators making huge fortunes.
Hearing of the financial successes in the tulip market more and more people started to participate which in turn drove the prices even higher.
Thus Tulip Mania was in full effect right up until February 1637 where the price, from all time highs, suddenly fell rapidly due to buyers failing to show up to a regular auction in Haarlem.
With a lack of potential buyers for their contracts the speculators started to sell off their contracts at huge discounted prices in an attempt to minimise their trading losses, leading to the bursting of the first ever economic bubble.
Whenever a market enters a bubble it is quite typical for there to be a failure among most participants to recognise that the pricing and valuation of the asset cannot be supported by previous valuation techniques.
Indeed the excessive speculation during Tulip Mania caused the price of a Sempur Augustus, the rarest and most sought after tulip variety at the time, to reach 10,000 guilders - enough to buy a mansion on the Amsterdam Grand Canal.
A flower for a mansion... obviously in retrospect it's easy to see how insane that is but during the height of the euphoria most, if not all, participants would've simply suspended their disbelief and been more concerned with not missing out.
To help us understand market bubbles the economist Hyman P. Minsky identified five stages in his book Stabilizing an Unstable Economy (1986) that basically explains the pattern of a bubble.
Displacement: Happens when investors become attracted to and fall in love with a new thing in the market, such as the newly introduce tulip.
Boom: With the attraction comes demand which in turn causes the value of the new thing in the market to rise. The rise starts slowly at first but as more and more participants get in on the action the speed of the rise increases. Soon, with widespread knowledge of the new fad the "fear of missing out" sets in and draws an increasing number speculators into the market.
Euphoria: Any and all caution is abandoned while prices skyrocket, supposedly justified by new methods of measures on valuation. As more and more participants buy into these new measures the "greater fool" theory - the concept that someone else is always willing to pay more no matter how high the price goes - will be in full effect.
Profit Taking: While speculators may continue in their euphoria, the smart money - financial professionals such as institutions, funds and central banks - will start to exit their positions for a profit. Typically they will be taking note of particular warning signs to try and gauge when to get out of the market, and ultimately making that move even though the markets may continue to be irrational for some time.
Panic: All it takes is a relatively minor event to burst the bubble, causing prices to reverse and start declining rapidly. In these moments, investors and speculators will be scrambling to liquidate their positions, almost at any price, to salvage what they can of their wealth. With an influx of supply and little to no demand the value of the asset will rapidly decrease in a race to the bottom.
Principles to avoid getting caught in a bubble
By looking at the five stages identified by Minsky it isn't difficult to see that the Tulip Mania basically meets all of these characteristics.
The most obvious lesson you might assume is to simply not participate in the bubble.
But this is probably more difficult than expected. Remember that all market bubbles are only really identified after they've happened, and during the excitement of it all it is easy for participants to lose sight of sensibility.
So instead I feel that suggesting a couple of principles based on what we've seen and learnt from past bubbles are a better approach to how an investor can avoid getting completely caught up in the hype, and hopefully save them from getting burned.
Since there were five stages to a bubble I went with five principles to follow:
Due diligence: Always take the time to do your own investigation and analysis into any type of asset that you are potentially going to invest into. Ask questions that will help you understand the fundamentals of the asset to give you a better idea on why it holds value to the world and what could affect that value, and also ask questions that could challenge those views so you're aware of the risks to that asset.
Even the people who follow a passive investing strategy need to at least understand the underlying reasoning behind it if they are going to be able to stick with it through thick and thin.
Deliberate: Whenever you come across a new exciting opportunity that seems to be rising in popularity don't just jump in based on the hype, hoping that someone else will buy it from you for a higher price based on the greater fool theory.
Come up with a game plan on what you're going to do under certain scenarios, such as if the price suddenly falls or if it goes up a lot. The more you know what you're going to do before you've even entered the market, the less panic you will be subject to if things go wrong.
Discipline: Successful investing involves minimising risk while maximising potential gains. This means you need to properly size how much of your own wealth you're willing to put into a new investment opportunity and understanding the impact it will have if it doesn't go the way you think it will.
A lot of your success can also come from what you do outside of the market. By putting yourself in a strong financial position (following a budget, managing debt, having an emergency fund etc) you will have a strong foundation that can help reduce your level of overall exposure to market falls.
Diversification: There will always be new opportunities in the market so risking everything on one single idea is rarely going to be the best course of action. Instead you should be spreading your investments across numerous different assets that aren't highly correlated to each other, so that your exposure can be balanced and mitigated.
If you've invested in a new exciting idea that doesn't go the way you hoped, you'll at least be safe in the knowledge that your other investments may actually be counter-balancing your losses. This could in fact give you the confidence to stick with that new idea and give it a bit more time to play out in full - your investment might ultimately be right but if you can't weather the storm by being over-exposed there's little to no meaning in you being correct in the first place.
Delayed gratification: The surest way to get caught up in a hype or a bubble is by chasing the idea of getting incredibly wealthy in a short amount of time. The allure of no longer needing to worry about money is among the biggest reasons for speculators to abandon all sensible reason in an attempt to get rich quick.
I'm not sure if the allure can ever be completely removed but learning to appreciate what you have in life, and enjoying your own journey towards financial independence is going to be important to your long term and sustained success.
Find other reasons besides money to keep going and understand that the financial aspect is just one part of the bigger picture. If you're truly going to live a fulfilled and meaningful life you will need to find a purpose - and once you've found a purpose I have a feeling that the temptation of taking a wild leap to get rich quick will no longer have the same pull as it might have done before.
Taking a market bubble in stride
While there does always seem to be someone somewhere out there crying wolf on the market - and if someone keeps doing so, they'll eventually be "correct" - it's hard to ignore that some assets or opportunities in today's world do appear to exhibit a number of aspects mentioned in Minsky's five stages of a bubble.
And some of these are assets that I'm involved in...
Author's note: I'll avoid directly mentioning which assets but if you're a reader of my blog it's probably quite obvious!
But even if I hold my own reservations on the continued and sustained success of certain assets - something I'll have to dive into in future articles - I do still allow myself some level of exposure. The important thing is that my exposure strictly follows the principles laid out earlier.
There could be numerous different arguments and perspectives to try and justify an investment, many of which you'll find on the internet simply by searching for reasons why investing into a certain asset is a good idea. But don't forget that one of the stages of a bubble mentions that new measures and metrics are part of the euphoria.
My reasoning is far more straightforward - you need to take on some risk in order to gain a reward.
I also believe that completely steering clear of anything and everything you think might be a bubble doesn't make total sense - because it's only in the most extreme cases where a bubble becomes obvious. Other opportunities might exhibit some bubble-like behaviours but eventually stabilise and become reasonable or even great investments.
How do you separate these out from the others?
In truth you probably can't.
It's a bit like trying to predict which of the companies in the S&P500 are going to continue existing, and continue to be successful, long into the future. You simply can't tell and the statistics say that the majority of them will be replaced by other companies within the next decade or two.
But that's why you buy them all - the index - so that you can have both the winners and the losers.
So why not treat any asset - even the ones that seem like a bubble - as simply another part of your overall portfolio?
You'll win some and you'll lose some - just like some companies in the S&P500 will succeed while others will not - but as long as you're following the right principles and doing the right things to avoid over exposing yourself your overall investment performance should in theory be positive in the long run.
Personally I love digging into history purely out of curiosity, and quite often there will be many lessons that can be gained through the experiences of others who have come before us. Before looking through the story behind Tulip Mania I certainly didn't know that the first stock exchange was in Amsterdam, nor did I know that the first publicly listed company was Dutch.
While these are interesting pieces of trivia the more important insights are in the patterns or behaviours that have been observed in such events, and in similar events that have come after them.
By knowing a little more about Tulip Mania and thereby understanding market bubbles a little better I feel it makes me even more prepared for the time where I will personally be faced with one.
Such an event is almost inevitable considering my age and the length of time that I will (hopefully) be involved in the market.
All of that being said however, there might not be anything that I personally need to do besides continuing my trusted strategy of passively investing into a well diversified index fund.
Think about it - if the fund is truly well diversified then theoretically it's eventually going to have some exposure to any asset that's bubble-like, directly or indirectly, provided it gets to a point where that exposure simply makes sense.
So that's ultimately how I plan to deal with a market bubble - by doing (mostly) nothing.
Author's note: Wow, what a roundabout way to get to that conclusion... but for me it just goes to show that the passive investing strategy is difficult to argue against and the real purpose of this article is to give a little more knowledge on the history of market bubbles, talk through the whole thinking process, and make both you and I that little bit more prepared for the future. Hope it was interesting at least!
Hey - just one final word before wrapping up - Dealing with the market is an exercise on managing risk rather than - as most people might assume - picking the next winner. Provided you understand this concept your aim is to find opportunities that offer an appropriate reward for the risk involved, and whether or not you can tolerate that risk.
I recently read an article by Super Saving Tips that talks about Risk Tolerance and How It Leads You to Rewards - a nice little read for anyone who's struggling to find their balance and needs a bit of guidance on their approach.