Sunday, May 22, 2011

The Unintelligent Investor's Definition of the Week: Bubble

Bubble

Oxford Dictionary’s definition: used to refer to a situation or feeling that is unlikely to last: many companies enjoyed rapid expansion before the bubble burst. A bubble of confidence

Unintelligent Investor’s explanation

Bubbles bursting are probably one of the most feared phenomenon to investors and traders alike. Many many many economists and “experts” try to predict formations of bubbles and anticipate when they might eventually burst. There are also many theories out there trying to explain how bubbles form and why inflated prices eventually correct themselves. I don’t know if there is one that is actually accurate.

From what I understand, when bubbles are forming, the economy is generally doing very well. People feel like they have great wealth and can afford to pay higher prices to acquire assets. The government tries to slow down the appreciation of assets by increasing interest rates, making it more expensive to take a loan (how effective this intervention is, is debatable). There is something called the “greater fools” theory, which is when someone, with lots of confidence buys an asset at a high price (fool) with the anticipation that they will sell it to someone else (greater fool) at a higher price. So the price keeps going up as long as there is a greater fool to buy the asset and when this stops, sellers greatly outnumber buyers and BOOM!

A country’s economy is usually badly affected after a bubble has burst. Imagine as investors or traders, you lose a huge chunk of your wealth and that gets worst if you have margin calls or if you have taken the wrong position when selling an option. You somehow have to cough up enough money cover these calls, what happens if you cannot renew your line of credit? You’ll have to severely cut down your spending. So the country not only have to deal with this sudden evaporation of wealth, it has to deal with the fact that people will stop spending money as well.

The movie Wall Street 2 talked about one of the 1st bubbles recorded in history, Tulip Mania (1637). During the Dutch Golden Age, tulips became so valuable that a single Semper augustus bulb can buy you 12 acres of land. The bubble eventually burst and the value of tulip bulbs became so low that people stopped trading it. Imagine being the person who bought the 12 acre of land with 1 bulb. It was a pretty good trade for him if you ask me lol.

Below is a chart of tulip prices that I got from wikipedia made by Earl Thompson


A few examples of bubbles that followed are:
Japanese asset price bubble
Asian Financial Crisis
The very popular Dot-com bubble
US housing bubble
Uranium bubble
Rhodium bubble
Etc.

Before the Great Depression started, margin requirements were only 10% so for every dollar you have in your deposit account, you are allowed to borrow 9 dollars. Just imagine how much buying power you’ll have and how ridiculously high prices could go. And when asset prices crash, imagine trying to repay those loans.

I guess bubbles forming and popping are inevitable. Its most probably all part of economic cycles. The best we can do is to be cautious. Take a level or risk that is confortable to us. And perform due diligence always! Does not matter how “hot” the stock is, do your homework! I know it is very hard to make a decision to stay out of a stock and watch the price go up and up and up, it can be very disappointing. What I found helpful to me is to remind myself why I decided to stay out of it in the first place instead of looking at what the stock is doing. When we made the decision to stay out, there was no way we could have known what the price is going to do and who knows, the prices could very well crash tomorrow.

Before the term bubbles were used, people used the word mania to describe this crazy inflation and deflation of assets. So dont be manic!

So what bubbles do you think are forming as we speak? And what do you think cause bubbles? Do drop me emails or comments. Type what you think of give me feedback on my post. I’m more than happy to read them. Thanks for reading! Do click on the little like button on the right hand side of the screen to like the page on facebook or follow me on twitter.

Next post on Tuesday!

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2 comments:

  1. sounds like ppl use future money to buy stuff...
    its not like they have the cash they are banking for it to generate cash in the future to make a quick buck and usually the enterprenuer is the one that gets somewhat best out of it.... they buy in bulk wait for the trend to keep going up and then sell in bulk making the price drop drastically.....
    now.... to do that with currency... hmmmm.....

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  2. I usually think of it as people buying stuff with money they dont have. But using future money is another way to think about it.

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