If we go through some financial history books, we will discover one major thing – markets once every generation can transform into these wild beasts that you do not know when will turn to bite you. On regular occasions, markets can crash, but in some cases than can even become depressed for a big period. Usually, the regular investor endures a few big fluctuations/depressions of the market.
But did history teach us how to expect such bad market times and how we can prevent them?
There are several key areas where an investor must be proficient – investment theory, history, psychology, and investment industry practices. The one that can cause the most damage from the former is a lack of investment historical knowledge. The history of investment gives you fundamentals to success in finance, by preventing you from doing the same mistakes as the past generations. In finance, we have this cyclical scenario where once every generation/decade we see the markets crash and then rise again.
The catalyst of stock prices going up is purely one thing – technological progress. If by any chance this progress stops, corporate profits will remain static and we won’t see any long-term rise of market(stock) prices. But how is capital driven into these new technologies? Pretty simple – usually new technologies tend to capture the public eye and big amounts of cashflow start to go towards them. After all, every investor wants to be involved with the next Apple, Google, or Facebook – future profits are too sweet to just let them go with ease. The capital raise process of the biggest companies usually happens for brief periods when there is a lot of public enthusiasm. In times like this once a generation a unique event occurs – an economic bubble.
Bubbles are often (for reasons poorly understood) connected with the investors’ ability to price business rationally. This usually happens when a new revolutionary technology is introduced or there is a major shift in the financial methods (easy acquirable credits that can be used to speculate with the market). But we can add couple more reasons when a Bubble happens – investors tend to forget history and its lessons that come with it and also the rational and smart investors are pushed aside by “investing gurus” that are willing to purchase everything that in a short time will bring them big profits. In summary, we can say that euphoria is the driving force here that makes investors purchase assets purely because their prices are rising.
So, to summarize the major factors for a bubble to happen are:
- A new, unique technology or shift in the financial system
- Easy credits
- Forgotten history lessons – forgetting about the most recent market crash
- Abandoning all principles of investing and just going with the flow, where all the investors are making irrational purchases of stock purely because their prices are rising.
Let’s take a look at huge Bubbles that happened in financial history.
The first case that we will look into is probably the most famous one – the Great Depression. The main reason for this economic disaster was once again technology – during 1920 there was such a huge technological industry boom – aircraft, automobile, electric generators, and many more engineering wonders were introduced in a pretty short period.
Well, you wonder what happens next?
Borrowing money got as easy as buying groceries and these new technology companies were flooded with capital. We already have 2 major ingredients for forming a bubble. The next factor is that it has been almost 10 years since the last major railroad enthusiasm and most investors forgot that history lesson. The final line was crossed when regular folks started to invest in these technological wonders because their neighbor was making huge profits and they’ve heard him talk about it. And indeed, some investors made money – in the next 2 and a half years the stock prices rose more than 150%, but in the years following 1930 the market prices plumed with 90%.
But why did this happen exactly?
The major characteristic of this era was the stock pool, which consisted of a group of wealthy speculators that gathered with the exchange specialists to drive up the stock price. The whole process was well orchestrated where the wealthy group will start to sell and buy specific stock between them. By doing so the stock price starts to bounce around in price that brings the attention to the public, which will start to buy this particular stock and drive its price to new heights, at which point the exchange specialist will “pull the plug” and sell the stock for enormous profits.
Another unique aspect of this era is the so-called “investment trusts”. Same as the mutual funds, they were operated by professional fund managers that were in charge of large portfolios of stocks and bonds. At first, these trusts were managed very conservatively, but once the 1920s technological revolution came in, they started to shift themselves in a pyramidical manner. They started to use borrowed capital used by individual speculators. By using this borrowed money, they started to increase the small stock price changes into these huge price swings in the trust’s price. After that they continue to abuse the system when these trusts started to buy their stocks, increasing the price even further. At this point, they started to unload the inflated shares on the public.
After the aftermath of the Great Depression, it took nearly a passing of a whole generation until the financial scene was ready for new financial speculation periods.
One of the most recent speculation (Bubble) periods was the so well know Dot Com Bubble.
Here we have the same scenario as the previous example – overpriced company shares where they starting price per share was $6, after that the price rose to over $200 and later plumed to under a $1. Again, all the ingredients were in place – new technological revolution, easy cash to borrow from banks, another (new) generation that forgot the history lessons, and again euphoria was in a place where your taxi driver is talking about purchasing stocks.
All of these history lessons should be a great warning to all future investors. There will always be speculative markets where the rules of investing to not apply. Your role as a smart investor is to discover them and think rationally (as hard as it can be when you are seeing the returns that your fellow investors are making) and give a proper assessment to the situation.
As we’ve discovered every investor once in a lifetime is witness to a big market crash and depending on your reaction during these hard times it will separate the good investor from the bad one.
One faithful day you wake up and check the news – all markets are going in the red and stock prices are hitting new lows every minute. As a human being your first reaction will be to panic, but that is the last thing that you should do. The majority of inexperienced investors will panic sell every stock that they own. This is a big NO-NO!
The biggest difference between a good and a bad investor is that the foremost figured out that bear markets are part of the financial life and you can’t run away from them. The second big difference is that when times get hard the good investor will stick to its game plan and the main investment rules, while the amateur will abandon all principles of investing and probably throw away all of his invested money.
The distinguishing aspects of a good investor
What you should do when prices start to fall dramatically is to increase your percentage in equity allocation, which requires you to buy more stocks, but you should increase them with very small amounts – 5% on every 25% reduction of price. That way you are preventing yourself from running dry on cash and missing a buying opportunity in the future when the markets stabilize and thrust me, they will.
In summary of this article, we hope that we managed to make you more prepared when manias and hysteria are seen in the market and how you need to sift through the information and make smart decisions regarding your investments. It is important to remember that markets in cyclical periods tend to crash and that even if today everything goes smoothly and the prices rise, you never know what will happen tomorrow. But it is also very important to remember that in times of rough market pessimism things almost always turn around. It is also valuable to remember the history lessons that we wrote about and when you have this tiny thought of doubt, go back to the financial history books and remind yourself what your actions should and should not be. Last, but not least, and probably the best lesson that history provided us is that in times of great optimism, future returns are lowest and when things look dreadful. Future returns are the highest.