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!

Tags: asset bubble, The Four Pillars of Investing, William Bernstein

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