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The Psychology of Financial Bubbles and How to Profit From Them

Why financial bubbles happen and how you can protect yourself from them

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We live in uncertain—and at times confusing—economic times. Inflation hit its highest point in four decades this summer. Everywhere you look, economists are predicting a recession. Interest rates are higher than they’ve been since the Great Recession in 2008. The housing market is cooling, with 83% of consumers saying “it’s a bad time to buy a house.” Many sectors, especially tech, are doing major layoffs. Yet, employment growth remains resilient and the stock market is climbing again.

Given all this uncertainty, it’s no surprise that many investors are looking for a safe place to shift their money.

Moving currency to safety

I recently wrote a long post on the difference between money and currency. As I wrote:

Today, the dollar is a currency. It can go up and down in value depending on how other currencies are performing and based on many economic conditions. It is tied to nothing and can move in either direction very quickly. In 2021, the “Wall Street Journal” wrote that the dollar was “dwindling”. Today, in 2022, “The New York Times” writes, “A Rising Dollar Is Hurting Other Currencies”...

So, what does it mean that the dollar is a currency? I find it helpful to talk about electrical currencies. An electric currency carries electricity from one place to another. In order to survive, a currency must be moving. Once it stops, it dies.

Similarly, the dollar as a currency is simply a vehicle to move wealth from one area to another. For instance, smart investors who saw the rout in the bond market coming in 2016 most likely moved their wealth from bonds to another sector that stood to benefit from higher interest rates and a rising dollar. Today, with inflation high, smart investors are most likely moving into commodities. It’s all cyclical, but the rich know that true money is now found in assets, not in the currencies that go up and down.

Today, with the threat of recession hanging over their heads, investors are now flocking to bonds. As CNET reports, “Though they've been protecting American investors' money against inflation since 1998, Series I savings bonds have never been as popular as they have been in 2022. Soaring prices near the start of the year created their highest ever interest rate -- 9.62% for I bonds purchased between May and October. The demand for I bonds this year has been so extreme that the Treasury's computer systems crashed when the record rate was announced in May, and the site experienced intermittent outages during the last few frenzied days the rate was available in late October.”

For years no one wanted bonds. Now, with inflation high, they’re the hottest thing in the market. A whole slew of articles have been published recently on how to buy them. All of this is a sign of currency moving.

Blowing financial bubbles

Because money is no longer money and is now a currency, it’s not surprising that we see many financial bubbles form. A financial bubble is simply an asset that is artificially inflated in value due to investor enthusiasm…and sometimes hysteria. Like real bubbles, financial bubbles grow and grow and grow and then…pop!

The bond market is a potential bubble that is ready to pop. The housing market is a bubble that seems ready to pop. Same with the stock market, which has been quite volatile. Cryptocurrency is a bubble that has popped with some violence. As with all financial bubbles, most amature investors will come in late and most likely lose their shorts while the smart money has already moved on to the next asset ready to grow.

Financial bubbles, a tale as old as time

Over the years, I’ve written about a lot of bubbles. This is because like death and taxes, financial bubbles are sure things in life. And they’ve been around for a long time. One of the biggest and funniest involved tulips.

In a nutshell, between the years of 1634 to 1637, the price of certain varieties of tulip bulbs, an especially prized flower, grew exponentially. Things really heated up in 1636 to 1637. Alastair Sooke, writing for the BBC, gives an good account of what was happening:

One of the curiosities of the 17th Century tulip market was that people did not trade the flowers themselves but rather the bulbs of scarce and sought-after varieties. The result, as Dash points out, was “what would today be called a futures market”. Tulips even began to be used as a form of money in their own right: in 1633, actual properties were sold for handfuls of bulbs…In 1633, a single bulb of Semper Augustus was already worth an astonishing 5,500 guilders. By the first month of 1637, this had almost doubled, to 10,000 guilders. Dash puts this sum in context: “It was enough to feed, clothe and house a whole Dutch family for half a lifetime, or sufficient to purchase one of the grandest homes on the most fashionable canal in Amsterdam for cash, complete with a coach house and an 80-ft (25-m) garden – and this at a time when homes in that city were as expensive as property anywhere in the world.”…In early February 1637, the market for tulips collapsed…Demand disappeared, and flowers tumbled to a tenth of their former values. The result was the prospect of financial catastrophe for many.

But modern day examples of financial bubbles also are easy to find.

Banks financial bubble

In 2010, The Wall Street Journal reported "Bargains on Failed U.S. Banks Are Over." According to the article, despite the fact that more bank failures were projected to occur in 2010 than in 2009, investors were pulling out of deals to buy failed banks from the FDIC because the prices were getting too high. In comparing 2010 to 2009, the average discount on failed bank assets was 9.5 percent versus 14 percent, the average buyer purchase gain as a percentage of assets was 2.5 percent versus 4.5 percent, and the cost to the FDIC of loss sharing pacts as a percentage of assets was 22 percent versus 27 percent.

By all accounts, and as insane as it sounds, though the market was worse and more banks were failing, some investors were paying more and driving up the price of failed banks.

Gold financial bubble

Also in 2010 Bloomberg.com published, "Gold Rallying to $1,500 as Soros's Bubble Inflates," stating that gold futures for December were trading at $1,500, which was 18 percent higher than the record gold price of $1,266.50 recorded on June 21, 2010. According to the article, one of the biggest purchasers of gold was George Soros, who called gold the ultimate asset bubble at the Davos World Economic Forum in January. Apparently, he thinks that despite gold's record pricing over the summer, we're just at the beginning of the gold asset bubble. In March of 2022, gold peaked at $2,066. I guess George was right. He probably made a lot of money. Those that purchased near the peak didn’t. Today, gold sits at around $1,700.

GameStop financial bubble

Take for example the GameStop craziness. As I wrote a while back in my post “GameStop, Retail Investors, and the 10 Controls of the Sophisticated Investor,” “On Friday, January 29, 2021, GameStop’s stock went as high as $380 and became one of the most traded stocks on the market. How did this happen to a mall store with a stone-age business model in the middle of a pandemic?”

The answer was euphoria. Amateurs rushing in to cash in on a rocket ride. GameStop eventually crashed down to the $40 range. Today it’s in the $20 range. Along the ride you can bet a lot of people lost a lot of money...and made a lot of money. But it’s all betting.

Cryptocurrency financial bubbles

Perhaps the ultimate example of paying way too much is the cryptocurrency market. I’m a fan of crypto. I invest in it. But I only buy it when it’s on sale. Unfortunately, many people wait too long, purchase at the top, and then are afraid to buy when it dips because they think they’ve “lost” money.

On November 12, 2021, Bitcoin peaked at $64,400. As of this writing, it's $16,416. Lots of amateurs were buying at the peak. Today, people are afraid of buying it. My guess is that professional investors are getting ready to purchase on the dip while all the amateurs are selling and losing.

Modern-day tulip crazes abound

Lest you think a phenomenon like the Tulip Craze was a historical anomaly by backwards folks from hundreds of years ago, you need only to look at our own crazes in modern times like the tech stock bubble of the early 2,000s, the sub-prime crisis in 2008, and even the designer fruit craze in modern day Japan, where it can cost up to £20,000 for a square watermelon.

As Mike Taylor in “The Psychology of Making Money,” writes about these crazes,

At each instance, seemingly rational individuals have been affected by the herd mentality, and have bought and sold assets at prices that did not reflect fair value. Often, investors justify their decisions by saying they are in a new paradigm and the current set of circumstances are set to continue forever. The reality is usually far from that - in fact, quite the opposite.

The psychology of financial bubbles

This all begs the question: why would people pay way too much on investments?

Most investors today think that the fun will continue. They firmly believe as Taylor writes that “they are in a new paradigm.” Taylor gives three reasons for this mindset:

Anchoring: This is a trait where an investor will "anchor" to a price that is important to them, but may have no relevance at all to the market they are investing in. For example, being focused on doubling your money, and only selling an asset if or when the price reaches this point.

Loss aversion: Recognizing a loss is uncomfortable for most people and investors will try to avoid it where possible. That means that if an asset is below the price the investor paid for it, they are prepared to wait in the hope they will get back to break-even. This can prove disastrous if the asset is in terminal decline. At best, it means your capital is stuck in a poorly performing asset when it could be reallocated elsewhere.

Herd behavior: From a young age, we learn to succumb to peer pressure as the path of least resistance. When it comes to investing, we take comfort if everyone else is doing the same thing. For example, if everyone is buying overpriced internet shares, even if your rational brain tells you this is madness, you justify your decision because, "all my friends are doing it and they are making money, so it must be OK".

Surely, Buffett understands how to avoid the three behaviors Taylor lists. As one of the richest men in the world, he doesn’t get sucked into the euphoria of the markets. He only profits from them. How?

A few years ago, when stocks were again setting records, Buffett mentioned he thought they still might be cheap. The important caveat from Buffett in his determination that stocks looked cheap was that it was based on an environment of low interest rates. "If interest rates were seven or eight percent, these (stock) prices would look exceptionally high," he said.

That is the difference between a professional inverter and an amateur. Buffett has market fundamental reasons for investing while amateurs are chasing euphoria. You can bet with interest rates rising today, Buffett will exit long before the amateurs do. He’ll make money--lots of it--and others will lose big.

The question I have for you is what will you do to be a Buffett and not a buffon? How will you profit from financial bubbles while others are ruined?

Financial bubbles always come and go...but will you profit?

One key to preparing and profiting from financial bubbles is to understand the nature of market booms and busts. This can be done by understanding history and then seeing the patterns of history in play in our world today.

Over the years, I have read several books on the subject of booms and busts. Almost all of them cover the Tulip Mania in Holland, the South Seas Bubble, and, of course, the Great Depression. One of the better books—“Can It Happen Again?”—was written in 1982 by Nobel Laureate Hyman Minsky.

In the book, he described the seven stages of a financial bubble. They are:

Stage 1: A financial shock wave

A crisis begins when a financial disturbance alters the current economic status quo. It could be a war, low interest rates, or new technology, as was the case in the dot-com boom.

Stage 2: Acceleration

Not all financial shocks turn into booms. What’s required is fuel to get the fire going. After 9/11, I believe the fuel in the real estate market was a panic as the stock market crashed and interest rates fell. Billions of dollars flooded into the system from banks and the stock market, and the biggest real estate boom in history took place.

Stage 3: Euphoria

We have all missed booms. A wise investor knows to wait for the next boom, rather than jump in if they’ve missed the current one. But when acceleration turns to euphoria, the greater fools rush in.

By 2003, every fool was getting into real estate. The checkout girl at my local supermarket handed me her newly printed real estate agent business card. The housing market became the hot topic for discussion at parties. “Flipping” became the buzzword at PTA meetings. Homes became ATM machines as credit-card debtors took long-term loans to pay off short-term debt.

Mortgage companies advertised repeatedly, wooing people to borrow more money. Financial planners, tired of explaining to their clients why their retirement plans had lost money, jumped ship to become mortgage brokers. During this euphoric period, amateurs believed they were real estate geniuses. They would tell anyone who would listen about how much money they had made and how smart they were.

Stage 4: Financial distress

Insiders sell to outsiders. The greater fools are now streaming into the trap. The last fools are the ones who stood on the sidelines for years, watching the prices go up, terrified of jumping in. Finally, the euphoria and stories of friends and neighbors making a killing in the market gets to them. The latecomers, skeptics, amateurs, and the timid are finally overcome by greed and rush into the trap, cash in hand.

It’s not long before reality and distress sets in. The greater fools realize that they’re in trouble. Terror sets in, and they begin to sell. They begin to hate the asset they once loved, regardless of whether it’s a stock, bond, mutual fund, real estate, or precious metals.

Stage 5: The market reverses, and the boom turns into a bust

The amateurs begin to realize that prices don’t always go up. They may notice that the professionals have sold and are no longer buying. Buyers turn into sellers, and prices begin to drop, causing banks to tighten up.

Minsky refers to this period as “discredit.” My rich dad said, “This is when God reminds you that you’re not as smart as you thought you were.” The easy money is gone, and losses start to accelerate. In real estate, the greater fool realizes he owes more on his property than it's worth. He's upside down financially.

Stage 6: The panic begins

Amateurs now hate their assets. They start to dump it as prices fall and banks stop lending. The panic accelerates. The boom is now officially a bust. At this time, controls might be installed to slow the fall, as is often the case with the stock market. If the tumble continues, people begin looking for a lender of last resort to save us all. Often, this is the central bank.

The good news is that at this stage, the professional investors wake up from their slumber and get excited again. They’re like a hibernating bear waking after a long sleep and finding a row of garbage cans, filled with expensive food and champagne from the party the night before, positioned right outside their den.

Stage 7: The White Knight rides in

Occasionally, the bust really explodes, and the government must step in—as it did after the 2008 crash, buying shares in companies like GM and bailing out large Wall Street banks that leveraged themselves too far.

Today, you should ask yourself what stage you think we’re in, and how will you profit from it? The good news is I have a five-point plan to share with you on how to be profitable in any market.

The Rich Dad five-point plan to profit during stock market corrections

The first step to success in any market is obvious enough, but too often ignored. Know what your money is invested in!

If you don’t plan on investing in financial education, then by all means, keep your money in your 401(k) and let it sit there. It’s safer than moving money without the knowledge of how or why. But if you want to be prepared to make money in any market, you need to understand how to make that money work for you.

A great place to start is by reading Andy Tanner’s Blog and the Rich Dad Blog.

  1. Know your position

    The sad reality is that most people don’t even know what their retirement money is invested in. The money gets pulled out of a check, goes to a magical place called a managed investment account, and is moved around by a wizard called a financial manager.

  2. Know how you’ll perform

    Once you understand what your money is invested in, you need to understand how those investments will perform in a given market. For instance, if interest rates are hiked substantially, as the Fed seems to be prepping for, there’s a good chance that stocks and bonds will fall—and these make up most investors’ retirement accounts.

    Therefore, in such a market, it may be time to invest in real estate before interest rates go higher.

  3. Get educated

    This means that you can’t just take advice about the market, you have to educate yourself so you can see what’s coming and have time to prepare.

  4. Slowly pare back your risk

    With the proper education, you can see better where the markets are going, how your current asset mix will perform in the coming markets, and how much risk you have. This allows you to make the proper adjustments to minimize your risk and take positions that will perform well whether the market is going up or down. And it leads us to the final point.

  5. Buy in pairs

    Professional investors always buy in pairs. One position is for growth, and the other is for protection. So for instance, if you’re heavily invested in the stock market and paper assets, you want to take an insurance stake in precious metals or commodities. If you buy real estate, you want to also buy insurance for that real estate.

    The list can go on and on. This of course takes financial education, but the investment is worth it.

Why financial education is a must-have to survive financial bubbles

Unfortunately, the average investor doesn’t understand the fundamentals of the markets, let alone how interest rates impact the value of stocks. They just buy because the market is going up…and everyone else is doing it.

And this brings up an interesting question. What’s the antidote to anchoring, loss aversion, and herd behavior? And how do you put my five-point plan into action with success?

The answer is found in financial education.

By understanding how money and markets work, you are better equipped to see the trends happening…and profit from them. Buffett has built his fortune doing just that. And so have I.

If you want to up your financial education, a good place to start might be these “A Different Financial Education (in 17 Definitive Lessons).

But you have to go deeper than that.

For instance, if you were interested in stocks, you’d benefit greatly from studying under Rich Dad Advisor, Andy Tanner. He can teach you to invest like Buffett—not like the average investor. Hint: it’s a lot more complicated than buy, hold, and pray.

I still believe the biggest stock market crash in US history is looming. I also believe that, with the right financial education, you can thrive while others struggle to survive. All it takes is moving past things like anchoring, loss aversion, and herd behavior to truly understand how money works…and how to make it work for you.

Original publish date: August 31, 2010

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