The Psychology of Bubbles: Using Hindsight to Examine Why We Bought into the Hype

I’ve been pounding the table pretty hard on investment bubbles lately. Probably because in the last decade, I’ve experienced more popped bubbles than I care to remember.

Or perhaps it’s that I’m constantly amazed by the herding behavior of humans. After all, we’re not that different from the rest of the animals on Earth, so it’s not difficult to believe that if our neighbor, our dentist, the stock analyst on CNBC, and even our local 6 o’clock news anchor says that everyone is doing it, that we’re afraid we’re going to be the Poindexter standing in the corner all by our lonesome.

Hey, if it worked so successfully for Obama’s behavioral psychologist dream team, why shouldn’t the “people want to do what they think others will do” vibe work on investors after the quick buck? It’s not mind control per se, it’s just a few highly intelligent prognosticators coming up with clever ways to get you to do something… before you know you want to do it.

Psychology of an Investment Bubble

Since I’ve gotten a fair amount of feedback — both for and against the presence of a gold bubble — I thought it would be fun to graphically examine the psychology of an investment bubble as it’s forming and after it has popped.

Moreover, what the emotions are like as different types of investors (value investors, fast money momentum traders, and Everyday Joe retail investors) were thinking as the newest investing fad forms a bubble, then quickly bursts.

Stealth Phase

More than likely, these are the value investors and buy on the dips investors. They’re probably the most infuriatingly patient and purposely coy investors on the planet because they will wait for months or years to get the right P/E ratio or the bad earnings report, and swoop in to buy as much as they can while it’s cheap as dirt. They really don’t care what the rest of the world is investing in at the time, they just want to get maximum value for their money invested. These are the Warren Buffett’s and Wilber Ross’ of the investing world.

Awareness Phase

These are the big money institutional investors who pour over stock charts and fundamental analysis screening programs 18 hours a day, and have a dedicated research team to be on the lookout for new opportunities. It’s their job to do the research, read everything down to the 10Ks, and beat the bushes to find the growth of a sector or commodity before anyone else does.

Mania Phase

This is when the investment goes 100% mainstream. It will get mentioned in every publication from the Wall Street Journal to The Today Show. This is when the bubble often traps the retail investor by showing past performance and gives the illusion of future appreciation (there is a reason why investments say past performance does not guarantee future returns). Then it begins to act a bit of a euphoric or narcotic like effect where it blinds the part of the brain that says “Wake Up You Smuck!” and all they think about 20% gains in a month and two stock splits a year. In other words, it’s purely unobtainable mania brought about by something proverbially spiking the punchbowl.

Blow Off Phase (aka – Bailout Phase)

Usually accompanied by a “it will come back” mentality and a general lack of comprehension that you’ve just been screwed but haven’t gotten the morning after thank you call. The big institutional investors and fast money traders will have predetermined stop loss orders in place, and when those are tripped in mass quantity, the bottom completely falls out and panic selling begins. The best traders will also begin to pile on the shorts accelerating the sell off. IN the end, the value will be pushed below the historical trendline since we’re just as likely to overreact on the downside just as much as we’ll overreact on the upside.

Examples from Bubbles Past

Oil Bubble

Who can forget that pesky thing called an oil bubble? You know you loved paying $4 to $5 for a gallon of gas… especially when you drove a SUV that cost around $100 to fill up every five days.

Notice the massive run up to $147 and the horrendous sell off back down to $35 per barrel. It took 5 years to create this bubble, but when it popped, man … look out below! [echos]

See any similarities between this chart, and the psychology of bubbles graphic above?

Real Estate Bubble

It almost makes you say WTF! Take a look at the massive deviation from the historical trendline. It begs the question if the real estate bubble was artificially created or if we had legalized marijuana back in 2000 and got happy with the mortgage paperwork.

Nasdaq Tech Bubble (aka Dot Com Bubble)

Who can forget the good ol’ tech bubble? That much loved period when America could do no wrong and any crappy company could create a website and double in value two months later. Sad thing was that these companies had great fundamentals (according to most everyone) and the huge run up in prices was sufficiently validated.

And you were vilified if you said anything to the contrary.

It was such a fiasco that finally in late 2009 — a decade later — that a small number of those high flying tech stocks are finally breaking even on their old 1999-2000 highs.

The Gold Bubble?

Now that gold has breached $1000 and apparently destined to above this price point forever, it almost makes you wonder if we’re just setting ourselves up for the same thing.

But take a look at the chart, the newspapers, and the people around you. Can you see the similarities between gold and the rest of these bubbles? Can you connect the dots?

Sure, gold has some good fundamental reasons for being above $1000 per ounce, but if you’re late to the party, do you really want to invest at these levels knowing that going long gold (and shorting the U.S. Dollar) are the most crowded trades on Wall Street.

Academic Inflation: The Mother of All Investment Bubbles

I keep a fairly watchful eye for investment bubbles, but the rise of America declaring war on work and degree factories pumping out diplomas (subsidized by Federal & State governments) not worth the paper their printed on have created an unsustainable academic system if Generation Y, and the generation behind them, can’t get a job to repay those student loans.

Bubbles have a nasty way of pulling future demand forward, so the short to medium term outlook might be bit uncertain to say the least.

(Notice how insignificant real estate inflation, and 2000-2007 real estate bubble, compare to the rise in college tuition & fees.)

One of my goals is to discuss sound personal investing.

Not exactly a novel concept I know, and I’m sure you can find a myriad of columnists and self promoting TV personalities screaming BUY! BUY! BUY! as loudly as possible just to get your attention.

I’m really not that sort of investor or blogger.

I’m more of the type to say when you should avoid a particular investment.  If everyone rushes in, it will obviously cause current market prices to spike abnormally high from historical trends, and that’s where I would like to think I can give SF readers a moment of pause before signing on the dotted line or clicking the BUY button.

Case in point, a school bus driver who bought a $800,000 home nearing foreclosure proceedings.  This home has lost $125,000 (~16%) from the purchase price, the family almost certainly bought at the peak of the real estate bubble, and they be lucky to fully recover from this financial setback if the home enters foreclosure proceedings.

Knowing How to Spot a Bubble

Spotting an economic related bubble isn’t difficult.  Whether it’s a bubble in the real estate market, a stock market bubble, or an individual commodity like gold, they are basically caused by similar factors and are rather easy to spot.

Simply take a look at historical prices, and look for a huge spike in market value.  If current prices have suddenly spiked abnormally higher from past values, then it could be a good time to sit on the sidelines, and wait for prices to become more reasonable.

For example, consider the housing crash of the late 2000s.  The chart below (click for larger view) is an illustration of just how severe the real estate bubble actually was compared to historical home prices dating as far back as 1890.

It doesn’t take a genius to spot the surge in prices.  If you bought at the top of the 2006 peak, you’re likely on the losing end of your home purchase and underwater on your mortgage.  Of course, if you still have the capacity to pay your mortgage there really isn’t a substantial problem unless you’re interested in selling the property soon.

Point being, if someone is out there screaming BUY as loud as they can, they might have a vested interest in getting you to purchase whatever it is there selling.  A Realtor or a mortgage broker maybe?

Combine that with the peer pressure of wanting to follow along with the herd and buy along side everyone else is a pretty substantial reason to jump in without using the proper judgment.  Keep fighting off the urge, and you’ll almost certainly find that in a few years, prices will come down and those same people who called you a moron for sitting on the sidelines will likely have lost tens of thousands of dollars.

Or better yet, giving you a chance to be a vulture investor and buy their assets at half price.