The German philosopher Hegel once said, “The only thing that we learn from history is that we learn nothing from history.” Today, by reviewing some past financial bubbles, hopefully, we can prove the esteemed Hegel wrong.
- Maintain a disciplined and consistent investment approach to withstand financial bubbles
- Focus on diversification and avoid getting swept up in the latest trends
- Keep a long-term outlook and avoid panic selling when markets become volatile
Financial bubbles are like roller coasters - prices soar rapidly and then plunge suddenly, leaving investors feeling disoriented. They occur when the price of assets, like stocks, real estate, or even tulips, shoots up quickly and deviates from its intrinsic value. A trigger, like rapidly increasing earnings or new technology, ignites investor excitement. FOMO (fear of missing out) soon kicks in, leading to speculation and further price increases. However, like all roller coasters, the ride eventually ends, sending prices crashing down and leaving those who didn't get off in time with significant financial losses.
Another unique feature of financial bubbles is its most frustrating: at a bubble’s height, most participants are completely unaware of being caught up in one. It is only in hindsight – after the damage has occurred – that a bubble becomes most clear.
By reviewing these past episodes, hopefully, readers will recognize that, like bear markets and market corrections, even bubbles happen with some frequency, and investors are well served to prepare ahead of time. The key is to not focus on identifying the bubble, but to maintain a diversified portfolio and a disciplined investment approach, which can serve as a steady anchor during a turbulent market.
Tulip Mania (Netherlands, 1630s)
The Dutch Tulip Mania may have been one of the earliest and most famous speculative asset bubbles. In the mid-1600s, the Dutch became prosperous, driven by trade and commerce. As traders and merchants grew their wealth, the affluent began to develop an increasing affinity for luxurious and exotic items. Among their prized trophies were tulip bulbs, which were treasured for their vibrant colors and intricate patterns.
Although demand for tulip bulbs continued to grow over several decades, it wasn’t until late 1636 that the true mania started. From November 1636 to the peak of February 1637, the prices of tulip bulbs increased exponentially. The price of one tulip bulb swelled to the equivalent of a Dutch working man’s annual salary. In some rare cases, the price could be as high as the cost of a well-apportioned home.
Suddenly, the frenzy dissipated in early 1637 as buyers failed to complete deals at previously agreed upon prices. Trading activity evaporated, sending prices crashing and leaving many in financial ruin.
South Sea Bubble (Britain, 1710s-1720s)
The South Sea Bubble was fueled by speculation in the shares of, you guessed it, the South Sea Company, which obtained contracts to supply slaves to Spanish America. Investors were excited about the potential profits from the Spanish trades and started to pile into the stock until the bubble burst in late 1720.
The most famous victim of the South Sea Bubble was Isaac Newton. At the time, the brilliant scientist was in his eighties and was one of the early investors in the South Sea Company. He enjoyed tremendous success when South Sea Company stock first jumped in value, selling out of his position and pocketing a large profit. As the stock price continued to increase, Newton bought back in around its peak in 1720 with large portions of his financial assets. Allegedly, he lost all his profits from the early investment and substantially more. Thus, his famous quote: “I can calculate the motions of the heavenly bodies, but not the madness of people.”
Japanese Bubble Economy (Japan, 1980s-1990s)
In the 1980s, Japan experienced an economic boom and was the envy of the world. This period, known as the "Japanese Bubble Economy," was characterized by rapid economic growth, soaring asset prices, and excessive speculation in real estate and stocks. At the peak of the bubble, the total value of Japan's real estate assets was worth more than the total value of all real estate in the entire United States. Based on some estimates, the value of Tokyo’s Imperial Palace alone exceeded the real estate value of the entire state of California. With the massive amount of wealth created, Japanese investors and businesses went on buying sprees of foreign real estate, stocks, and companies. One of the most notable acquisitions was that of the Rockefeller Center in New York City.
However, when the bubble burst in the early 1990s, the Nikkei plunged by 60% from late 1989 to August 1992, and land values dropped by 70% from 1990 to around 2000. The bursting of the bubble led to a severe economic downturn known as the "Lost Decade," characterized by low growth, deflation, and high debt levels.
Dot-com Bubble (U.S., 1990s)
Starting in the late 1990s, many internet-based companies saw their stock prices soar, only to eventually crash and burst in the early 2000s. The euphoria was supported by the consensus outlook that the internet was the future, even though many companies had no visible path to profitability.
Two individuals stood out during this period for not having been drawn into the mania: Warren Buffett and Mark Cuban. Buffett avoided investing in any dot-com companies, stating that he did not understand the businesses well enough to confidently invest in them. Although he underperformed in the years leading up to the burst, he was proven right in the end.
On the other hand, Mark Cuban, a billionaire entrepreneur and owner of the Dallas Mavericks basketball team, made a fortune during the dot-com era. He sold his company, Broadcast.com, to Yahoo for billions of dollars. Even more impressive, he used trading strategies to protect $1.4 billion in Yahoo stock as part of the deal as the dot-com bubble burst. Sadly though, many other investors and companies suffered in the aftermath.
Housing Bubble (U.S., 2007-2009)
The housing bubble is one that remains fresh in many investors’ minds, having precipitated the global financial crisis. Low interest rates and relaxed lending standards fueled investors’ appetites for purchasing properties and speculating on the continued appreciation in real estate values. At the time, many purchased properties using subprime mortgages, which targeted borrowers with lower credit scores and allowed them to buy houses with little or no down payment. These loans also often had adjustable rates, meaning that the monthly mortgage payments could increase, sometimes substantially, over time.
As U.S. house prices started to fall in 2007, a rising number of borrowers could not repay their loans, leading to widespread defaults and foreclosures. The crisis in the housing market bled into the banking sector, as one bank after another suffered significant losses on mortgage loans. Ultimately, these losses prompted the failure of Lehman Brothers and other well-known financial institutions, which then rippled throughout the U.S. and global markets, causing the worst economic crisis since the Great Depression.
Takeaways – How Do We Invest During Volatile Markets?
Unfortunately, bubbles do happen with surprising frequency. As an investor, the important approach is not to avoid them altogether but to learn how to manage through them. In many of these bubbles, it was easy to think that sitting out would equal missing out. During the Japanese property boom, one may have felt that everyone around them - friends, relatives, neighbors - was getting rich. It can be hard to second-guess the opinions of people we know, but no one is impervious to getting swept up in the excitement - even someone as brilliant as Isaac Newton.
However, it is precisely in these volatile markets that maintaining a diversified and disciplined investment approach becomes crucial. Allow me to illustrate this point using the tale of the Johnson family and their journey through the two most recent bubbles.
Back in January 1995, the Johnson family started making investments in order to prepare for their retirement. Every month, they diligently contributed $1,000 to their investment portfolio, that held a combination of 60% in stocks and 40% in bonds. By early 2000, the Johnsons had accumulated around $100,000 just as the tech bubble peaked. In the next two years, while the S&P 500 dropped close to 50% from peak to trough, their portfolio's value remained flat – thanks to continued contributions and steady fixed-income returns.
The Johnson family had made it through one financial bubble relatively unscathed. But the global financial crisis would test them again. Following the same strategy of investing $1,000 monthly in a combination of stocks and bonds, their retirement fund continued to grow in the following years. By 2008 their portfolio had reached around $400,000 just before the housing bubble burst. Amidst the ensuing chaos, stocks plummeted, and the Johnsons' retirement fund dropped to approximately $300,000. But here's the incredible part: their portfolio swiftly regained its value, bouncing back to its previous peak in just two and a half years.
What made the Johnson family so successful was that they didn’t get swept up in the latest fad, whether it was tulips or houses. And they also didn’t worry if there were bubbles around them. The secret to their success was a straightforward and unwavering commitment to a diversified portfolio and disciplined investment strategy.
Be bold, yet prudent. Stay diverse, yet disciplined. Even Sir Isaac Newton would agree, a simple yet disciplined approach can help manage through a turbulent market.
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Source: Kestra Investment Management with data from FactSet. Index proxies: S&P 500 Index and Bloomberg U.S. Aggregate. Data as of December 31, 2012.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Private Wealth Services, LLC, Kestra Investment Services, LLC, Kestra Investment Management, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by any entity for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Private Wealth Services, LLC, Kestra Investment Services, LLC, Kestra Investment Management, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC does not offer tax or legal advice.