22 Dec

On Bitcoin, Bulbs, and Bubbles

December 22, 2017

Bitcoin BubbleIn the 1630s in Holland, tulips were a relatively new flower. (The first tulips came to Europe from Turkey in 1554.) The flowers were perceived as a luxury, so they were in high demand across Europe and there was a limited supply. In the mid-1630s, speculation entered the market. The price for tulips began to rise beyond the “rational” price of a flower. By early 1637, the highest valued tulip bulbs were selling –singly – for more than ten times the annual income of a skilled worker. In February 1637, the craze played itself out, the values of tulips plummeted to more rational levels, and many people lost a great deal of money. Holland’s bulb bubble burst.

Such is the way with market bubbles. Where rational long-term investing is focused on strategic asset allocation, matching up a target portfolio return with the minimum possible systematic risk, bubbles ignore rationality altogether. The focus shifts from utilizing fundamentals to determine the proper value for an item to imagining the future price appreciation of the item. Speculation ensues and many people begin purchasing the item without even understanding its fundamental characteristics.

Hallmarks of a Bubble

The rise in cryptocurrencies over the past year has been fascinating: witnessing a market bubble in real time is somewhat eerie. Of course, the last two major market bubbles led to terrible crashes: tech stocks in 2000 and real estate in 2008. In the event of a crash, hopefully Bitcoin and its cousins will not have such far-reaching effects, as the market is much smaller.

Here are some hallmarks to watch out for with bubbles:

  • Scarcity – Bubbles thrive on assets that have a limited supply. As more people become interested in purchasing, there is a struggle to create more of the asset, forcing prices to rise quickly.
  • Headlines – Bubbles need an ever-expanding pool of entrants into the market, and a compelling story brings headlines to the media that drive interest in the product.
  • A Mystical Product – Bubbles can be accelerated when they involve an investment that is difficult for the average investor to understand. This complexity can lead speculators to avoid further research and focus exclusively on the price appreciation.
  • Price Dislocation – In all bubbles, the price of the asset rises rapidly (creating the headlines in the first place), followed by a meteoric price rise as new entrants flood the market that further increases the upward pressure on the price.
  • Wide-ranging Market Participants – When your barber, landscaper, or housekeeper begins talking about their “investment,” you know a bubble is reaching an unsustainable crescendo. (Or in today’s world, when JP Sears makes a video about it!)

Greater Fool Theory

Bubbles thrive on the “Greater Fool Theory”: to make money, you don’t need to understand an asset or its true value; you simply need to be able to sell it for a higher price to a greater fool. Like every game of hot potato, though, someone has to be out. And at some point, the final investors who paid the most for the asset are left to pay the price for the party.

Principles to Follow

I will not say you need to stay totally out of the current “Bitcoin bubble,” but here are a few good principles if you choose to participate in this, or any, speculation:

  • Don’t invest an amount that would damage your long-term goals if you were to lose all of it. I have heard many people over the last weeks wishing they had put their entire retirement savings into cryptocurrency a few months ago, but the fact is that speculation is not the way to handle a retirement portfolio. The return opportunity may be significant, but the risk involved is equally, if not more, significant.
  • Recognize that the risk is greater than you think it is. Bubbles are notorious for seeming like a “sure thing.” I remember college professors in the late 1990s conjecturing that we may have seen the last of bear markets with the masterful techniques of the Federal Reserve and the new markets created by the Internet. How wrong they were.
  • Learn about the market before you invest. Cryptocurrency is a sign of an evolving world economy. There are elements of it that are changing our world systemically. Take advantage of the opportunity to learn about it before you purchase it.
  • Keep your investment to a limited amount, even if the bubble rages on for months to come. I learned long ago never to predict when an investment is going to fall. Bubbles are by nature irrational. They don’t follow the rules, but they will look most attractive immediately before their drop. Otherwise, buyers would not be entering at that peak. Avoid the temptation of expanding your investment, particularly if the possible loss could damage your long-term goals.
  • Recognize the bubble for what it is. This is not a true investment. It’s not what you would do with the majority of your portfolio. It is speculation: a boom that will ultimately bust. Remember: at the end of the day, the emperor has no clothes.

The Bitcoin Bubble Takeaway

Finally, don’t let the feeling of “missing out” cause a rash decision to invest. Like wishing you had won the lottery, this kind of thinking can be damaging. Remember: you’re a long-term investor with well-defined goals and a strategy to get there. Putting your portfolio at risk for a speculative return could put you in a tough place. In fact, maybe it’s a good time to review that plan with your trusted advisor!

For more on the history of market bubbles, Extraordinary Popular Delusions and the Madness of Crowds is the definitive text on the topic. Written in 1841, it still rings true at the end of 2017!

This update has been provided for informational purposes only and should not be construed as individual investment or tax advice. Please contact your investment and/or tax professional(s) to discuss your personal situation.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner™ and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

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