courtesy of flickr.com/photos/amagill/

Now that you have a basic definition of a stock bubble, let’s look at the underlying factors, or what I call the recipe for a stock bubble.  Why do you care to know how bubbles form?  Because bubbles burst.  And when they do, people lose lots of money.  People like your brother-in-law who cashed in his 401(k) to invest in Snuggies stock, who is now living in your basement.  Once you understand the recipe for stock bubbles, hopefully you can see them forming early and steer clear.

Because your brother-in-law needs somewhere to live.

Once again, we turn to The Four Pillars of Investing by William Bernstein to give us the ingredients for a stock bubble. Once two or more of these factors are present in a market, bubbles form (these ingredients come in no necessary order):

The first is a “displacement”, which in modern times usually means a revolutionary technology or a major shift in financial methods.

The second is the availability of easy credit—borrowed funds that can be employed for speculation.

The [third] is that investors need to have forgotten the last speculative craze.

And [finally], rational investors, able to calculate expected payoffs and risk premiums, must become supplanted by those whose only requirement for purchase is a plausible story.

Voila!  The four ingredients.  In order to bring them from abstraction to reality, let’s see if and how each of the factors was present in the bubble burst of 2007, what many call the real estate or housing bubble.

Ingredient One

Were there any technological or financial innovations that transformed the market?  Heck yes! Ever heard of Mortgage-Backed Securities or Credit Default Swaps?  Crafty financial minds came up with new ways to package mortgages as investment tools and created methods to insure them.  Too bad so many of the mortgages these investment tools were built on were “sub-prime”, meaning the lenders defaulted en masse on their mortgage loans.  And when the sub-primers defaulted en masse, the insurance companies didn’t have enough to cover them!

Ingredient Two

Was credit easily available? Hmm, why don’t we ask the dogs and dead people who were offered pre-approved, no questions asked solicitations for credit cards?  Another example, perhaps you’ve seen Maxed Out, where a loan officer assists a mentally handicapped man sign his name on a loan application (the handicapped man was incapable of working or earning an income).  Or this: The mid-2000s gave us NINJA loans (No-Income-No-Job-or-Assets)!

Ingredients Three and Four

According to Bernstein, ingredients 3 and 4 “can be summarized in one word: euphoria. Investors begin purchasing assets for no other reason than the fact that prices are rising.”  Investors were definitely euphoric: in the mid-2000s stocks were going up and up.  The big institutional investors, Bear Stearns, Lehman Brothers, etc were buying and trading all the Mortgage Backed Securities they could get their hands on.  When other institutional investors saw the profits coming in, they jumped onboard.

Unfortunately, bubbles burst.  All of the “profits” and “asset appreciation” were built on speculation and euphoria.  Lehman Brothers went under, AIG got bailed out, and no one is happy.

Hopefully, now that you know what a bubble is and the conditions necessary for their formation, you can keep a cool head and continue diversifying your investments.  Remember, your brother-in-law is going to need someplace to live.

courtesy of: flickr.com/photos/amagill/

Back from Winter Break and ready for action! I read some very interesting books over vacation and as a result have many posts lined up with new information about investing, behavioral finance (how emotions affect our money habits), and why index funds beat actively managed funds.

But to begin with, I thought I would post about the financial topic that has been dominating the news for the past two years: the stock market crash and resulting recession.

The term stock market “bubble” gets floated around a lot, most times between people who only have a foggy idea of what it means, but know that it impresses other ignorant people when they say it.  So here, now, I’m going to spell out exactly what a stock bubble is.

Why Should You Care?

Well, perhaps so that the next time one comes around, when everyone and their grandma is mortgaging their houses to buy Snuggies’ stock (because “it’s the next big thing!” you’re brother-in-law assures you), you can keep your head cool.  You’ll keep on investing in index funds, diversifying your asset allocation, and when the Snuggies bubble pops and your brother-in-law has to move in with you, you can tell him “Told you so!”, as he cooks you a hot pocket.

Back to the Explanation…

Let’s turn to my friend William Bernstein, author of The Four Pillars of Investing: Lessons for Building a Winning Portfolio, who gives us a clear and simple definition of a stock bubble:

Bubbles occur whenever investors begin buying stocks simply because they have been going up. The process feeds on itself, like a bonfire, until all fuel is exhausted, and it finally collapses.

Quite simply, a stock bubble is the result of the bandwagon effect.  Like in middle school, when all the cool kids stopped wearing whitie-tighties and switched to boxers.  You had to do it too.  Sure, boxers offered less support and were more prone to wedgies, but EVERYONE WAS DOING IT.

Fast-forward 20 years, and for the same reasons, you buy Snuggies stock.  It’s going up! And, everyone is buying it! Well, it’s going up because everyone is buying it, not necessarily because of any increase in intrinsic value.

Now that you know what a stock bubble is, you can use the term with wisdom.  But simply knowing the definition won’t help you see them coming and avoid them.  That’s why next post I will give you the recipe for a stock bubble: I’ll spell out the factors needed in a market for a bubble to form.  Stay tuned!