Bubble vision

Source: New York Times

Carl Richards is a certified financial planner in Park City, Utah. His sketches are archived here on the Bucks blog. His new book, “The Behavior Gap,” will be out in January.


During a recent conversation, someone asked me if I thought the last few years made me better equipped to spot the next bubble. Since we had recently been through a real estate and credit bubble could anyone credibly claim that they would be prepared to spot the next one?

My response was simple: no.
While the last few years hasn’t made me any better at bubble spotting, it has made me realize that when it comes to investing it’s truly better to be safe than sorry. For anyone who thinks that living through a market that clearly got ahead of itself somehow makes you better able to forecast the next bubble completely misses the point.

The supposed ability to spot bubbles is just another way of talking about market timing. Market timing, while not impossible, has certainly proven to be highly improbable.

It’s certainly tempting to believe that somehow we could identify a variable or series of variables that would tell us when the market was officially in a bubble. It reminds me of a conversation I had a few years ago where somebody who was clearly exasperated said, “All I want is for someone to tell me to sell before the market goes down and to buy before it goes up. Seems quite simple to me!”

Looking for a bubble spotter is just the latest way we’ve come up with to trick ourselves into thinking that there is a way to time the markets. We can get very sophisticated in the stories we tell ourselves. We look for things like quantitative models, advanced forecasting software, years of academic research and studies. But in the end, it’s all just market timing. And for the most part, it simply doesn’t work.

One of the big problems with some of the recent bubble spotting methods is that they work perfectly, just so long as you’re looking backwards. Many of these techniques are based on extensive research that relies heavily on back-tested models.

We are very good at analyzing the past and coming up with surefire ways of avoiding the exact same mistake again in the future. But what we are particularly bad at is thinking about things that we have never thought of before. Most bubbles are blazingly obvious with the benefit of hindsight, but when we’re honest with ourselves, we have to admit that often they were caused by things that we hadn’t even considered possible. And the exact cause of the next bubble will surely be different than the cause of the last bubble.

This current obsession we have with bubble spotting isn’t new. It’s just the latest reincarnation of the age-old desire we have to make sense of the world around us and have some sense of control about the future. But if we do want to use history as a guide, we need to realize that even those that were best positioned to spot bubbles have been wrong.

In July 2009, The Wall Street Journal surveyed 50 economists about where interest rates on the 10-year Treasury bills would be one year later. Rates were sitting at 3.3 percent when the article came out. Forty-eight respondents said they would be higher one year later, while only two suggested rates would fall below 3 percent. The rate was 2.95 percent on June 30, 2010.

And it’s not just in recent times that the bubble predictors didn’t get it right. As Jason Zweig recently noted in The Wall Street Journal, even the guy who wrote the most famous book about bubbles missed a big one:

On Oct. 2, 1845, [Charles] Mackay wrote that “those who sound the alarm of an approaching railway crisis have somewhat exaggerated the danger.” He went on to ridicule anyone who argued that “the Railway mania of the present day” was similar to the devastating bubbles he had described in his own book. “There is no reason whatever to fear” a crash, he concluded. He couldn’t have been more wrong. From 1845 to 1850, railway stocks fell by two-thirds — the equivalent of roughly $1 trillion of losses in today’s money. Mackay never fessed up to his own extraordinary delusion.

So back to the original question. If we’re not any more prepared to spot the next bubble than we were just a few years ago, then what?

The point is we should stop trying to trick ourselves into believing that if we just buy a bigger computer, hire the right analyst, find the secret newsletter and read enough magazines or books then we’ll somehow be able to buy before the market goes up and sell before the market goes down.

We need to give up on the idea of timing the market and finally pay attention to the academic research that shows it’s a fool’s errand. Instead we should devote at least some of that time to developing a financial plan that starts with where we are today and plots a course to where we want to go. Once we have built a plan, no matter how basic, then we can figure out how we need to invest our money to meet those goals.

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