Biases that create bubbles

by **Cals** Sun 10 Apr 2016, 23:28

Biases that create bubbles

BY MARK REIJMAN

We speak about a bubble when an asset class – such as gold, Bitcoins, housing or stocks of Internet companies – quickly rises in value due to speculation. Bubbles always burst because they are not sustainable in the end. This is because the value of the assets is detached from its intrinsic value.

Bubbles are caused by cheap credit and herd behaviour. Herd behaviour – or groupthink – occurs when people start to follow other people, rather than think for themselves.

If enough people move into the same direction, attracting more and more people to join, they create a snowball effect. This is sometimes also called the bandwagon effect, as more and more people jump on the bandwagon.

Property bubble

A few influential people or companies may start buying property because they believe that property prices will go up. If they receive enough media attention, more and more people will also start buying property.

As the increase in demand pushes prices up, the early investors seem to be right and receive applause for their foresight. This will attract even more people to buy property. In this manner, the rise in property prices becomes a self-fulfilling prophecy, which gives it even more plausibility.

Now prices rise all the time, but what makes it a bubble is that the prices are unsustainable. Prices are unsustainable if it is impossible for investors to earn a competitive return in the long term.

The same process in reverse happens when the bubble starts to burst. Some people are starting to sell the asset, drawing attention from the media.

Other people start to follow and a panic starts. Once everybody begins selling, the market becomes illiquid and prices fall massively. After a period of downward and upward adjustments, the market settles again at a more reasonable level, ready for the next bubble.

Examples

There are many examples of bubbles. One of the most well known is the first Internet bubble that burst in 2000. Today, there is widespread speculation whether all the ‘unicorn’ Internet companies – companies with a private valuation exceeding $1 billion, such as Uber, Lazada and AirBnB – are truly worth that much.

One of the oldest bubbles in recorded history was ‘Tulip mania’, during the golden age in The Netherlands. The newly introduced tulips quickly became an inspirational luxury item, which could be worth more than an annual salary. Some also argue that London and Kuala Lumpur are currently experiencing housing bubbles.

Dangerous investment strategy

You can make money by investing early in a bubble and selling before it bursts. However, this is a very dangerous investment strategy that I would not recommend. It is extremely hard to judge where you are in the life cycle of a bubble.

By definition, most people only read or hear about the bubble when it is already well underway.

It can take years for a bubble to burst and your investment horizon might not be long enough. Also, you don’t know for certain whether an asset experiences a genuine rise in prices or is a bubble.

Remember that for every buy and sale you do, there is another investor on the other side of the transaction, who also thinks he is making a smart transaction. What makes you so certain you are smarter than the other party?

Mark Reijman is co-founder and managing director of [You must be registered and logged in to see this link.] dedicated to increasing financial literacy and to help you save time and money by comparing all credit cards, loans and broadband plans in Malaysia.