Financial Autonomy: Crackle & Pop! - Why do investment markets have bubbles

Crackle & Pop! - Why do investment markets have bubbles - Episode 63

Oct 17, 2018

Episode 63 – Why do investment markets have bubbles?

If you’ve ever seen a graph of any share market, you will know that whilst over the long term it tends to go up, the graph isn’t a straight line. Markets will go up, up, up over several years, only to fall back for a year or two, before re-starting their upward climb.

Research on United States investors shows that whilst over 20 years to the end of 2017, the S&P500 share market index returned 7.2%, the average investor experienced a return of 5.29% per year. I don’t imagine Australian investors would be much different.

This under-performance of investors has been observed for many years, so what’s going on? And how does it relate to market bubbles?

Market bubbles, and their subsequent busts, reflect over-reaction. We bid up prices beyond that which makes sense, and then on the downward slope, we sell when we don’t need to, and prices go below what logic would dictate they should be.

These extremes have nothing to do with balance sheets and profit and loss statements, and everything to do with human behaviour.

In behavioural finance (for which one of the key founders, Richard Thaler, won a Nobel prize in 2017), the term used is herd behaviour. We sometimes also refer to it with the acronym FOMO – Fear Of Missing Out.

Market bubbles don’t occur because investors are stupid. They happen because we’re human. We’ve learnt through thousands of years of evolution that if a lot of people are running in one direction, it’s probably wise to do the same. The luxury of waiting to confirm for ourselves that there is indeed a danger worth fleeing from, may well lead to our death.

So when markets keep rising, as we’ve seen in Australia over the past decade with residential property for instance, or when they fall, like we experienced with global share markets through 2008, our inbuilt, human reflex, is to jump on the band wagon.

Another thing that is happening is a concept known as Recency Bias. This is the human trait of disproportionally considering things that have happened recently, and dismissing older information.

As an illustration of recency bias in action, if you make an initial foray into some shares, and in the first 6 months they rise 10%, then you're quite likely to put more money in. And if that also rises quite quickly, you start thinking about where you can borrow money from to invest some more. This positive feedback loop is how bubbles emerge.

Interestingly the two most famous share market bubbles of the twentieth century, the bubble in American stocks in the 1920s just before the Wall Street Crash of 1929, and the Dot-com bubble of the late 1990s, arose from optimism surrounding the development of new technologies. An amazing range of technological innovations including radio, automobiles, aviation and the deployment of electrical power grids arose during the 1920’s. The 1990s was the decade when Internet and e-commerce technologies emerged.

The potential long term impact of these new technologies is hard to evaluate, which leaves plenty of room company share prices to climb, even when they are losing money.

So why should you care about investment market bubbles?

The answer ties in with the Dalbar statistics I mentioned in the introduction. An investor in the US could have earnt 7.2% over 20 years simply holding onto a well-diversified portfolio that reflected the index. Yet the average investor in fact only experienced a return of 5.3% because they followed the madness of the crowd. They bought and sold when they should have just left things alone.

The selling is what does the real damage. There is no perfect time to buy, it’s only known with the benefit of hindsight. And the cost of waiting on the side lines can be significant. But the selling is something we can be smart about.

To start with, don’t sell when markets are in a panic. Recognise the herd mentality and step back to consider what is right for you. In 2008, as markets declined, I had clients in their 30’s and 40’s asking if they should get their superannuation out of shares. I had to point out that they can’t touch that money until at least age 60, so short term falls are certainly not a reason to change plans. Indeed for accumulators, markets falls have the silver lining that you are a buyer, and prices are cheap.

Also during that period I saw recency bias in action. People would say – “my balance has fallen x% this past year. If it keeps going like this for another 5 years, I won’t have enough to retire on”. But hang on, we know that the long term average return for growth type portfolio’s is around 8%. So why would you extrapolate last year’s down year and assume that’s what the future holds? Recency bias – applying disproportionate weight to recent returns.

Rebalancing portfolios can be a useful tool. That’s the process of periodically selling down investments in particular asset classes that have done well, and re-allocating the proceeds to the underperforming sectors. So for instance if the Global Share portion of your portfolio had a very good year, you would sell down some of this holding, and reallocate it to the weaker sector, perhaps Australian Bonds for instance. Considerable research has shown that this rebalancing process can add significant value. But it goes against the grain. It’s the opposite of what we naturally want to do, so it requires discipline.

To wrap up then, investment markets experience bubbles because humans make it so. And despite all the advancements in technology that we’ve seen in recent years, human behaviour hasn’t changed, so bubbles will continue to occur.

So what should you? Be a long term investor. Ensure your wealth strategy won’t force you to sell when markets drop. And if your strategy doesn’t already have a rebalancing process, explore how you might be able to change things to gain this valuable feature.