“Is this market a bubble?” and “Is my kid a genius?” are two questions which are asked far more often, and with less profit, than they should.
Financial advisors probably dread the asking of the one, just as much as teachers fear the other.
That’s because both questions, when asked by the typical investor or parent, embed both a delusion of detective skill and a wrong-headed idea of the point of the exercise.
You will very likely not be able to work out the answer, and will be prone to make the wrong move even if you do.
Moreover, and this applies equally to bubble hunting or genius cultivating, you make the cardinal error of putting yourself firmly at the center of an operation in which you belong well on the periphery.
Your kid probably isn’t a genius and won’t be helped, and may well be hurt, by your interest in the matter.
The market probably isn’t in a bubble and your consideration of the matter sets you on a path to do more harm then good.
“The bubbles that did not burst are just as important for investors to know about as the bubbles that did burst. Placing a large weight on avoiding a bubble, or misunderstanding the frequency of a crash following a boom, is dangerous for the long-term investor because it forgoes the equity risk premium,” Yale finance professor William Goetzmann wrote last year in a study of bubbles in financial history. ( here )
“In simple terms, bubbles are booms that went bad but not all booms are bad.”
What Goetzmann found is that booms are more likely to be followed by another boom than by a bust.
Looking at 21 national stock markets since 1900, 14 percent of the time stocks doubled in real terms over a three year period, or what we might call a boom.
Subsequent to this markets which doubled halved 3.37 percent of the time in the following year but doubled again 8.37 percent of the time.
Stretch that out to five years and post-boom markets double again a bit less than 50 percent of the time but only halve about 8.0 percent of the time.
Get out after a boom and you are more likely to miss another boom than a bust.
Clearly, unless you are exceptionally good at bubble detecting you are playing with fire in attempting to pick them out.
FOREVER BLOWING BUBBLES
Of course bubbles, those artificial and unsustainable increases in asset prices, like geniuses, exist and of course they make a big impression when they come around.
Bubbles happen for a complex and fascinating set of reasons.
A short list of causes would need to include human psychology and the fear of missing out, monetary policy and its late tendency to see asset price rises as a means to achieve aims previously met by genuine innovation and fiscal policy.
It is also true that the fact that we benchmark the managers we hire to steer our mutual and pension funds means they have an in-built motivation to chase irrational market valuations higher. If they sit out bubbles they are more likely to get fired.
That helps to drive both genuine booms and bubbles alike. The person who can determine which is which, especially the person who is simply managing their own retirement or long-term savings risk, is a rare bird and unaccountably in the wrong job.
So, sure, an optimum execution of investment would avoid bubbles, but a typical investors’ main risk isn’t that they might be subject to a downdraft but that they, in seeking shelter, may miss out on equity gains while doing so.
Investors, like parents, should aim to do reasonably well and act cautiously, and with a proper respect for how little they know about the future and what will be for the best.
Exceptional phenomena, like crashes or child geniuses are just that, exceptional, and best left to worry about themselves.
Bubbles, therefore, are a problem, but one which individuals are in a very poor position to mitigate. Policy makers should worry about bubbles, which can be more destructive to human and economic capital then they tend to be to portfolios.
Better fund management incentive systems and more symmetrical monetary policy around potential market bubbles would be a good thing.
You, on the other hand, are more than likely to do yourself, and your portfolio, damage by trying to time bubbles