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How to avoid losing money in economic bubbles

Stephen Eckett on the next financial fads and how to avoid them

3 March 2018

9:00 AM

3 March 2018

9:00 AM

Do you remember the Beanie Baby crash of 1999? Chris Robinson, an actor who appeared in the TV series General Hospital, certainly does. He invested $100,000 hoping to fund his kids’ college education and lost everything — well, apart from 20,000 stuffed toys in his garage. At the peak of the fad in 1999, just before the market plunged, Beanie Babies were selling for up to $5,000 each and accounted for 10 per cent of eBay sales.

That was just one in a long history of economic bubbles, including tulip mania in the 1630s and the stock of the South Sea Company 100 years later. We’ve had them in bonds, real estate, canals, railways, commodities, derivatives and now, possibly, Bitcoin — almost anything that has a price. We know with hindsight that they are all mad, and that they suck in clever people, including Sir Isaac Newton, who, having lost money in the South Sea bubble, commented: ‘I can calculate the movement of the stars, but not the madness of men.’

Yet if you can spot a coming bubble in the early stages of inflation — and you are wise enough to get out in time — you certainly won’t end up looking insane. After all, some academics argue that bubbles are perfectly rational, in that at every point the chance of higher returns fully compensates investors for the possibility that the bubble might collapse.

So what is going to be the next bubble? A simple definition of a bubble might be: an asset trading at a price far in excess of its intrinsic value. The harder it is to put an intrinsic value on something, the easier it is for people to fool themselves they’re paying a reasonable price for an inflated asset.


As the Economist recently pointed out, digital assets with no income streams are very hard to value. So an obvious place to look for future bubbles will be in the universe of digital assets. If online identities ever become tradable, they could turn into bubbles. If the clever people at investment banks manage to securitise access to air and water, air bubbles and water bubbles would be feasible, and likely.

Then there are cannabis-related investments. At the beginning of this year, California became the latest US state to legalise recreational marijuana. According to Forbes, cannabis-related businesses constitute one of the fastest-growing industries in the US, with the medical marijuana market alone expected to grow to $13 billion by 2020.

There are still regulatory hurdles to overcome in the US, but as these are cleared away, expect pot-heads, and prices, to get high. Cannabis investments will add a new meaning to the term ‘joint stock company’.

The aftermath of some bubbles can have a very negative effect on the wider economy — for example the fallout from the credit crunch in 2008. Yet some bubbles, while they lose money for investors, leave behind an infrastructure that benefits wider society. Canals, railways, and the internet needed excess speculation to raise sufficient funds to build expensive infrastructure. Some investors lost out, but later generations benefited from it.

Blockchain, the technology behind Bitcoin, may turn out to be another example. But when a commodity or product becomes subject to a bubble, the people who usually end up making the most money are the service suppliers. In the Californian gold rush, it was the people selling shovels that made money, not the miners. Today, it might not be Bitcoin buyers but the service industries around it that end up with the biggest riches. Bitcoin broker Coinbase booked $1 billion in revenue last year.

Another technology to watch are the ones related to batteries for electric cars. But not every new technology will turn into a bubble. Bubbles have a social element of sucking in a mass of people, creating a popular delirium, whereas lithium, or graphene, are likely to see just a few small companies go pop. One problem for ordinary people is that it is often difficult for them to invest in new technologies early on as the companies developing them may be private, or government-owned (especially in the case of China). By the time ordinary investors can get their hands on it, they might be too late.

Bubbles tend to occur during long periods of low interest rates, leading to increased debt levels and investors chasing income. Today, thanks to quantitative-easing by central banks, we have what some call the Everything Bubble, which includes stocks, real estate, fine art, corporate credit, auto and student loans. So at the moment it might be more a case of preserving your money by identifying which bubble is going to burst first, rather than looking for new ones.

High asset prices are often justified by the four most dangerous words in investment: it’s different this time. When polite dinner conversations turn to, say, the relative merits of Bitcoin and Ripple, it is a warning sign if you want to protect your investment portfolio from bubbles. And avoid any asset with a name like Old Face Teddy.


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