Valuation – Mania’s & Bubbles

“How not to be your own worst enemy”

Valuation – Mania’s and Bubbles

Introduction

The first stock exchange was found in 1602, the first equity bubble was 118 years later – why do bubbles occur?

Usually a great story: Internet will change the world House prices don’t go down (in the US) This times its different

If efficient market theory is true how can it be that bubbles exist?

“At the peak of tulip mania, in February 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman. It is generally considered the first recorded speculative bubble”

So how can we watch out for bubbles……

Valuation – Mania’s and Bubbles

If we define a bubble as a (real) price movement that is at least two standard deviations from the the trend then:

Assuming efficient market theories, a bubble should should occur every 44 years

However, there have been 30 bubbles since 1925 (roughly one every three years)

Each of those bubbles burst returning it to two standard deviations

Statistically that should happen according to efficient market theories every 2000 years not 30 times in 87 years!

Valuation – Mania’s and Bubbles

Why bubbles?

Over optimism – people believe they are better than they really are

Illusion of control – people believe they will know when to get out

Self serving bias – people believe what they want to believe

Inattentional blindness – people don’t pay attention to what they are not looking for

Valuation – Mania’s and bubbles

Take a sport like basket ball:

Team in white and black

People asked to count number of passes made by white team

Half way through guy in a gorilla suit walks to the middle court beats his chest and walks of

60% of people failed to see it, caught up in counting the passes

Valuation – Mania’s and bubbles

Bubbles are a by product of human behaviour, they have the same pattern Change in circumstance – internet creation

Credit creation – finance available

Euphoric – mania

Financial distress

Revulsion

They will continue to happen because its who we are…