Fundamentals of Investing: How to Survive and Thrive During Financial Bubbles
The German philosopher Hegel once said, “The only thing that we learn from history is that we learn nothing from history.” Today, by reviewing some past financial bubbles, hopefully, we can prove the esteemed Hegel wrong.
Summary
- Maintain a disciplined and consistent investment approach to withstand financial bubbles
- Focus on diversification and avoid getting swept up in the latest trends
- Keep a long-term outlook and avoid panic selling when markets become volatile
Financial bubbles are like roller coasters - prices soar rapidly and then plunge suddenly, leaving investors feeling disoriented. They occur when the price of assets, like stocks, real estate, or even tulips, shoots up quickly and deviates from its intrinsic value. A trigger, like rapidly increasing earnings or new technology, ignites investor excitement. FOMO (fear of missing out) soon kicks in, leading to speculation and further price increases. However, like all roller coasters, the ride eventually ends, sending prices crashing down and leaving those who didn't get off in time with significant financial losses.
Another unique feature of financial bubbles is its most frustrating: at a bubble’s height, most participants are completely unaware of being caught up in one. It is only in hindsight – after the damage has occurred – that a bubble becomes most clear.
By reviewing these past episodes, hopefully, readers will recognize that, like bear markets and market corrections, even bubbles happen with some frequency, and investors are well served to prepare ahead of time. The key is to not focus on identifying the bubble, but to maintain a diversified portfolio and a disciplined investment approach, which can serve as a steady anchor during a turbulent market.
Tulip Mania (Netherlands, 1630s)
The Dutch Tulip Mania may have been one of the earliest and most famous speculative asset bubbles. In the mid-1600s, the Dutch became prosperous, driven by trade and commerce. As traders and merchants grew their wealth, the affluent began to develop an increasing affinity for luxurious and exotic items. Among their prized trophies were tulip bulbs, which were treasured for their vibrant colors and intricate patterns.
Although demand for tulip bulbs continued to grow over several decades, it wasn’t until late 1636 that the true mania started. From November 1636 to the peak of February 1637, the prices of tulip bulbs increased exponentially. The price of one tulip bulb swelled to the equivalent of a Dutch working man’s annual salary. In some rare cases, the price could be as high as the cost of a well-apportioned home.
Suddenly, the frenzy dissipated in early 1637 as buyers failed to complete deals at previously agreed upon prices. Trading activity evaporated, sending prices crashing and leaving many in financial ruin.
South Sea Bubble (Britain, 1710s-1720s)
The South