The Paradox Of Investment Bubbles
By: Tony Yiu
Tags: Finance, Investing, Business, Stock Market, Money

Photo by Alfred Kenneally on Unsplash

Not intended to be investment advice. Opinions are my own.

The most interesting thing about investment bubbles to me is the fact that we never learn. Each time we (including me) come up with numerous reasons and rationalizations why, “This time is different.”

Yet when we look at past bubbles, it all seems so obvious in retrospect:

We laugh at the “fools” who paid a mansion’s worth in gold for some tulip bulbs many centuries ago.

We mock the “fools” who lost fortunes in DotCom bubble companies like Pets.com or WebVan. These profitless companies were “such obvious bubbles”.

We watched The Big Short and couldn’t believe how long it took everyone to realize that the subprime real estate market was a house of cards primed to collapse.

Past investment bubbles are analyzed to death and narratives are formed as to why it should have been obvious and why next time it will be.

But when next time comes around (like it has right now), no one is willing to leave the party early. Bubbles seem obvious, but in real time they are incredibly hard to spot, and even harder to avoid.

Emotions, self-doubt, and FOMO (fear of missing out) make the desire to capitulate and join in on the exuberance extremely hard to resist. This is further exacerbated by all the bullish noise arguing for further gains and warning you that you’re missing out on the opportunity of a lifetime.

It’s ironic that overconfidence makes us look back on past bubbles and say “I would never make such an obvious mistake like that” at the same time that we eagerly rush headlong to invest in the next bubble.

Looking To 2021

I might be wrong about the current market being frothy. I have also been prone to err on the side of caution. But as we head into an uncertain 2021, I would keep in mind the following:

In the long run, it is profits and cashflow that matter for equities. Central banks can mess with the discount rate as much as they want; but if there are never any actual profits to discount, at some point it will finally matter to investors.

Don’t invest out of FOMO just because some dude on the Internet says you’ve missed the opportunity of a lifetime. There will always be new opportunities. Biotech stocks in 2012, FANG stocks in 2013, Bitcoin in 2014, Bitcoin (post crash) again in 2018, S&P 500 put options in 2019, tech stocks in 2020, Tesla over and over again, etc. Every year there are opportunities to make very handsome returns, you just need to do your due diligence.

In the short run, price rises tend to beget further price rises as investors chase returns and everybody bends over backwards to create a narrative that rationalizes the surge in prices. But take all those narratives with a grain of salt; the truth is often much simpler — the reason that something like Bitcoin keeps going up is just because it’s been going up. Everyone is betting that they won’t be the last one to get on the train, and that as more people pile on, prices will keep rising. The “there will be a greater fool than me” approach to investing is not a sustainable one.

The bull case for many risky assets (such as stocks) seems to be low or negative rates forever. The bull case for crypto and precious metals is high inflation, dollar debasement, and persistently low or negative cash yields. Both groups of assets are soaring. Yet if inflation starts spiraling out of control, interest rates will likely rise, especially on the long end of the yield curve where the Fed exhibits less control. Higher interest rates would crush risky asset prices and bring down inflation. In an ironic twist, shorting Treasury bonds (rather than owning them) might be the best hedge for the risky assets in your portfolio going forward.

Personally, I head into 2021 with a portfolio that balances aggression (tech stocks and stocks poised to do well if the vaccine is a success) and caution (covered calls, index shorts, and put options on Treasury bonds). If markets keep surging, I’m prepared to underperform because of my various hedges. If things take a turn for the worse, the preparation I did in advance will allow me to sleep well at night. Good luck and happy new year!