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Home > Asset Management Best Practice > Booms, Busts, and How to Navigate Troubled Waters

Asset Management Best Practice

Booms, Busts, and How to Navigate Troubled Waters

by Joachim Klement

Executive Summary

  • We review the typical anatomy of financial market bubbles and subsequent crashes.

  • We show that financial innovation has often triggered exuberant market developments, leading to unjustified market optimism and catastrophic losses for many investors.

  • We emphasize the role that psychology and behavioral biases play in market dynamics before, during, and after a crash.

  • We provide tips on how to navigate volatile markets more effectively in the inevitable bubbles and crashes of the future—inevitable because of the very nature of investor psychology and financial markets.

A Brief History of Bubbles and Crashes

For many, the tech bubble of the late 1990s is probably the most prominent example of a stock market boom and bust. Figure 1 shows the exuberance in the Nasdaq Composite stock market index, which includes a significant proportion of technology and telecommunications stocks, compared to the S&P500 Index of the 500 large-cap stocks from traditional sectors like industrials, transportation, utilities, and financials. As the internet and information technology spread throughout society, investors became ever more optimistic about the growth prospects and profit potential of companies involved in IT.

But irrational exuberance, as former Fed Chairman Alan Greenspan called it, is not a phenomenon of the information age. It has taken hold of financial markets time and again throughout history. Table 1 summarizes a selection of stock market slumps after periods of irrational exuberance in the United Kingdom and the United States since 1800. Two observations stand out: Bubbles and crashes are not rare, reoccurring at intervals of 10 to 30 years, and the subsequent market declines typically eliminate from 15% to 50% of the peak market value. Assets such as commodities, sovereign bonds, and currencies have also frequently shown signs of irrational euphoria followed by a severe correction.

Table 1. Selected UK and US stock market booms and busts since 1800. (Source: M. Bordo, 2003, UBS Wealth Management Research, as of July 25, 2008)

UK boom and bust events
Boom (stock market increase, %) Correction Decline from peak (%)
Latin America mania 1822–1824 (+78%) 1824–1826 –37.3%
American boom n.a. 1835–1839 –23.4%
Railroad boom 1840–1844 (+52%) 1844–1847 –34.1%
European financial crisis n.a. 1874–1878 –31.0%
Roaring twenties 1920–1928 (+137%) 1928–1931 –60.3%
Housing boom 1931–1936 (+110%) 1936–1940 –50.1%
Go-go years 1965–1968 (+67%) 1968–1970 –18.9%
Tech boom 1994–2000 (+89%) 2000–2002 –24.8%

US boom and bust events
Boom (stock market increase, %) Correction Decline from peak (%)
Railroad boom n.a. 1853–1859 –50.6%
Railroad boom 1875–1881 (+51%) 1881–1885 –26.7%
Rich man’s panic 1899–1902 (+30%) 1902–1904 –16.3%
World financial crisis 1903–1906 (+52%) 1906–1907 –19.4%
Roaring twenties 1920–1929 (+168%) 1929–1932 –73.4%
Post-war slump 1941–1945 (+90%) 1946–1949 –10.8%
Go-go years 1965–1968 (+31%) 1968–1970 –15.7%
Tech boom 1994–2000 (+130%) 2000–2002 –27.7%

The Anatomy of a Crash

A closer examination of asset price bubbles reveals that the behavior of markets often follows a common pattern that comprises at least four stages:

Innovation

A common ingredient in market bubbles, innovations are often based on concepts that are difficult for a lay person to understand, like the information technology boom, or the biotech bubble at the end of the 1990s. Investors cannot assess the true potential of an innovation for a company’s earnings growth or productivity. Innovation in a favorable economic environment increases company earnings, but these initial successes may ultimately have limitations that may be unknown to investors. Since no historical evidence is available about possible risks, market participants may underestimate risks and project excessively high initial growth rates, ignoring the inherent limitations of growth for a new technology.

Exuberance

In a second stage, the presumed benefits of innovation and a new economic era are increasingly overestimated. Prices of stocks or houses continue to rise steadily and markets tend increasingly to ignore risks. Often, risks are only acknowledged after they materialize in the real world. This is the time when euphoria begins and investors clamor to get into the market “because prices can’t go down” and “this time it’s different,” or “this is a new era.” High profits attract new investors, and this in turn leads to higher returns as cash pours into these markets. A lack of liquidity in the markets may lead to further exuberance when demand becomes much bigger than potential supply. Especially in illiquid assets like houses, short-term demand can drive prices far from fundamentally justified values.

Crash

The positive feedback loop cannot last forever. At some point fundamental forces lead to a trend reversal. The result is often a rapid and steep decline in asset prices as the bubble bursts and the market crashes. The consequent loss in wealth can lead to lower consumption or investments in the real economy and can even destabilize the financial system. The effects can include recessions, or banking and currency crises as we witnessed in 2008. Here, a lack of liquidity can increase the fall in asset prices when sellers want to unload their investments at any price and illiquid investments may have to be sold at the worst possible time. In the financial crisis of 2008 it was the forced selling by hedge funds, private equity funds, and other investors that partially contributed to the sell-off of stock markets in the second half of 2008.

Regulation

A crash frequently is followed by increased regulation to prevent similar events from happening again. It is interesting to note that as a result of regulation and the lessons learned from a market crash, the exact same events are indeed very unlikely to recur and financial market stability is increased. But, as time passes, the positive effects of regulation fade. Market participants tend to forget about the causes and consequences of past bubbles. Who today considers the lessons of the go-go years of the 1960s, or even remembers them? Every generation can repeat the mistakes of previous generations, as is confirmed by the emergence of bubbles roughly every 20 to 30 years.

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Further reading

Books:

  • Kindleberger, Charles P., and Robert Z. Aliber. Manias, Panics, and Crashes: A History of Financial Crises. 6th ed. Basingstoke, UK: Palgrave Macmillan, 2011.
  • Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds. 1841. Online at: www.gutenberg.org/ebooks/24518
  • Nofsinger, John R. The Psychology of Investing. 5th ed. Boston, MA: Pearson, 2013.
  • Plous, Scott. The Psychology of Judgment and Decision Making. New York: McGraw-Hill, 1993.
  • Shiller, Robert J. Irrational Exuberance. 2nd ed. New York: Doubleday, 2006.

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