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Psychology of Market Bubbles

Financial Bubbles

The phrase ‘bubble’ has many times in history been attached to financial assets. The idea goes that when a market is overvalued – whether that be property, stocks, luxury items or any other asset – buying pressure forms a bubble which grows as demand uncontrollably climbs higher than supply. Once this bubble reaches a certain size and the value becomes too overstretched, it bursts.

Unlike with the bubbles you played with as a child – where fine raindrops of soapy liquid would fall harmlessly to the ground upon release – when the trust-based system of finance reaches a point where the speculative value become emotional rather than logical, it results in market crashes, economic downturns and global recessions. Essentially, the price of the asset rapidly falls from the sky, creating financial havoc for millions of investors both small and large.

The Mississippi Bubble

It was 1719 in Mississippi when such a bubble began to form.

The French government was drowning in unpaid debt, interest rates were too high and the economic climate was becoming growingly unstable. A Scottish businessman named John Law acquired the Mississippi Company whose aim was to colonise a piece of land on the lower bank of the valley which we would later go on to know as New Orleans.

This was an ambitious project but Law saw an opportunity to kill two birds with one stone and resolve the outstanding French debt, as well as completing his building project. The government agreed and the debt was exchanged for shares in the company which by now had been listed on the Paris Stock Exchange. In addition to this, Law was given the role of central bank governor which further increased in leverage within the economic circle.

Shares were initially offered to the general public in May 1719 at 500 livres. It was around this time that Law and his Mississippi Company began to exaggerate the resources that the valley held, claiming untapped reserves of gold and silver, beaver skins and other items of high worth. As word spread, the elites, businessmen and entrepreneurs of their time rushed in to buy shares at this initial price before the market rose and it was too late!

Speculation grew because of the innate fear behind human emotion, causing the share price to rise. By the beginning of August, shares traded at 2,750 livres, by the end of the month, that figure had risen to 4,100. The round psychological figure of 5,000 was soon taken out and by 2nd December, the price reached 10,000 livres.

Irrational Exhuberence

The word ‘millionaire’ is a French word which incepted from this very event after many people of all social classes became very wealthy practically overnight from the rising share price of the Mississippi Company. “People sold all their possessions and took huge loans in order to buy Mississippi shares” says Noah Harari.

In January 1720, the share price fell slightly from its all-time highs of around 10,000 livers due to the fact that some investors were selling their profits at the market peak and reinvesting the money elsewhere. There were only a select few who released that this was a wildly overvalued market and took the sensible option to not amass more wealth and be lured into the trap of greed but to be content and grateful with what they had acquired.

Bubbles tend to “pop”

The selling of shares increased as fear and uncertainty rose. Rumours that the valley was not the rich land of opportunity it was once claimed without gold and silver. This further discouraged investors and encouraged the exiting of the market.

In an attempt to hold up the share price, the French government bought tons of shares in the company as well as began printing more money to continue this buying spree. It didn’t work, the price continued falling and now more rapidly than ever.

By December 1720, the share price had plummeted back down to 1,000 livres and because the whole French economy was now in this bubble, debt was much higher than it had ever been. This triggered severe economic depressions in many other European colonies, Britain being one. With the next few months, the Mississippi Company would go completely bankrupt, the share price devoid of value at zero.

That was 1719. Fast forward just shy of 300 years and the narrative was that we have been gifted the same home-run financial opportunity. The 2017 cryptocurrency bullish run enticed investors in again to buy at the highs of the market only to lose large amounts of their investment when the bubble popped.

Bitcoin’s 2017 Bubble

A December 2017 article by CNBC highlights this similar comparison: “People are taking out mortgages to buy Bitcoin”. Many speculative investors borrowed money from banks, family, friends to buy into this soaring digital asset at anywhere between $15,000 and $20,000, emotionally over-stretching their greed and fear as those Mississippi investors once did. At the beginning of 2017, Bitcoin was trading at $1,000 and if you were interested in investing, that would have been the wise time to do so.

Mark my words, history will repeat itself. If you think that what we have witnessed so far has been parabolic, just wait. Millions of hopeful investors will be lured into the seemingly ‘risk-free’ investments of cryptocurrencies when Bitcoin is trading at $100,000, $150,000 and even more during the next bullish market. ‘If it has risen so much, why can’t it continue rising?’ they will claim. And that is when the bubble will burst once again.

The past is our tell for the future. What came before us will come again in a different cloak, but with the same shadow. As though we are antibodies protecting the immune system of our host organism from the foreign invaders, known as antigens, we must be diligent in identifying these threats to both our financial and mental equilibrium.

History is perhaps the most important subject on humanities syllabus. Investing because of fear of missing out or emotions like fear, uncertainty and doubt which again create an anagram of FUD will be your downfall in succeeding in the markets. We must learn from the past and not make the same mistakes that both our previous generations did and our previous self-did.

DCA

The strategy which still holds as the best for long-term investing whilst removing emotions from trading is Warren Buffet’s Dollar Cost Averaging which states that you should buy the market either at incremental psychological price points such as $2, $3, $4 and so-on or at date intervals such as weekly or every 4 days irrelevant of price. By removing emotions from your life, you can control what memories you store and what your subconscious believes. Ultimately, you can be more in control of your thought patterns and the types of bubbles you are in.

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