Principles: Bubbles are Rational
Shrinking Time Horizons
There is a difference between volatility and a market meltdown. US stocks fell 21% from May to October of 2011 and then quickly recovered; that’s volatility. The Nasdaq fell 80% after 2000 and didn’t recover for a decade; that’s a meltdown.
The fact that markets can go from volatile to meltdown, like a bubble, makes rational sense. It makes so much sense that we should expect it to keep happening.
One of the biggest flaws in academic finance is the idea that assets have a single rational price in a world where investors have different goals and time horizons.
How much should you have paid for Yahoo! stock in 1999? The answer depends on who you are.
If you have a 30-year horizon, the intelligent price to pay was a sober analysis of discounted cashflows over the next 30 years.
If you have a 10-year horizon, it would be an analysis of the industry’s potential and whether management can deliver on this vision.
If you have a 1-year horizon, it would be an analysis of current product cycles.
If you’re a day trader, any price is possible, because you are trying to squeeze out a few basis points of profits before lunchtime.
When investors have different goals and time horizons, prices that look ridiculous for one person will make sense for another, because factors of consideration are totally different.
Many investors who owned Yahoo! stock in 1999 had time horizons so short that it made sense for them to pay an expensive price. Money chases returns. Bubbles form when the momentum of short-term returns attract enough money such that the proportion of investors shifts from long-term to short-term.
As more short-term investors push up short-term returns, they attract more people until the dominant price setters are those with ever-shortening time horizons.
The phenomenon of rising valuations in a bubble is just a symptom of time horizons shrinking.
Blaming Irrational Exuberance?
You may claim that the dot-com bubble was rooted in irrational optimism about the future. But it is not true. Investors were not thinking multi-decades, the average mutual fund had 120% annual turnover, meaning that they were thinking in less than 1-year time frames.
The reasoning is similar to the housing bubble. People who plan to flip houses in a few months into a liquid market with upward price momentum; they don’t care about price-to-rent ratios. It is irrelevant to their game.
We can label these people as speculators, or irresponsible risk takers, or disapprove of their willingness to take big risks.
But we can’t call them irrational. Because bubbles are not about people participating in irrational long-term investing, it’s about people moving rationally towards short-term gains.
What do you expect people to do when momentum creates returns? People don’t sit and wait patiently… they flood into the market to play a game where valuations are ignored because it’s irrelevant to their game.
This makes bubbles more rational than often portrayed.
Different Games Played
The dangers of bubbles boil down to people with different objectives, while thinking that they are playing the same game.
Imagine these two market participants: A daytrader who is willing to buy a stock just to sell it before the market closes. And a grocery store worker who was saving for retirement 40 years later.
In a market where short-term players dominate, the grocery worker has to pay an expensive price, and if paid, would materially reduce his chances of retirement. Whereas the trader doesn’t care as long as the direction of price movement favors him.
Although both players have different games, they are forced to play in the same field since there can only be one quoted price.
Bubbles do damage when long-term investors take cues from short-term players.
We often cannot see that rational people are looking at the same world through a different lens than our own.
When short-term players dominate the field, it signals to the long-term players that rising prices are reflective of long-term worth. This can turn value oriented players into optimists, detaching from their own reality just because of the actions of someone playing a different game.
Few things matter more in investing than understanding your own time horizon and not be persuaded by price actions caused by people with different time horizons.
No matter what kind of player you are, the key is not to play games that you don’t intend to play.