Key Points:
- Crypto asset bubbles follow a predictable trajectory.
- They often start with a promising new technology that can transform society.
- Early investors make significant profits, attracting more participants.
- As more people join, prices rise beyond their fundamental value.
- Tightening monetary policies eventually lead to a crash.
- Investors pledge to avoid future bubbles but often succumb again.
- Patience, skepticism, and studying financial history can help resist the temptation.
“At some point in the growth of a boom all aspects of property ownership become irrelevant except the prospect of an early rise in price.” — John Kenneth Galbraith
Asset bubbles have been a recurring phenomenon throughout history, and it is inevitable that more will occur in the future. This is because human beings have a herd instinct ingrained in their brains due to thousands of years of evolution. Although every bubble feels unique, they tend to follow predictable patterns. The recent crypto mania of the 2010s and 2020s is no exception and aligns with the typical trajectory of a bubble.
1. A New Innovation with Potential Mass Market Applications Emerges
Most asset bubbles form around a promising new technology that has the potential to transform society. Examples of such innovations include canals, railroads, consumer electronics, and e-commerce. The mass market appeal of these technologies makes it difficult to identify the bubble in the moment, as most people believe it is not happening. Crypto advocates, for instance, argue that cryptocurrencies represent the foundation of a new decentralized financial system that will render traditional banking and fiat currencies obsolete. However, they overlook the fact that central banks were designed to mitigate the risks of a decentralized financial system.
2. Early Investors Make a Windfall
Early investors in asset bubbles often experience significant returns on their investments due to their timing advantage. However, their success is often attributed to luck rather than skill. These investors become celebrated figures, and their achievements are touted in the media, which encourages more people to participate in the bubble. This self-reinforcing hype cycle intensifies, and the early investors are hailed as market gurus.
3. Late Adopters Inflate the Bubble
The reckless enthusiasm of early investors, combined with the fear of missing out (FOMO), motivates late adopters to join the frenzy. The influx of new capital drives prices far beyond their fundamental value. Traditional investment principles are discarded to justify the irrationality of the bubble. Dot-com companies, for example, were once valued based on their user acquisition rather than profitability. Similarly, cryptocurrency exchanges operate without the regulatory safeguards of traditional banking systems.
4. The Supply of Money Tightens
As the mania progresses, inflated asset values and tight labor conditions may lead to inflation. Central banks respond by tightening monetary policies to reduce the availability of money. In the case of cryptocurrencies, investors are currently experiencing this pressure. If central banks do not intervene, the bubble may continue until the money runs out on its own. At that point, there is no mechanism to stop the deflationary spiral.
5. Panic and Crash
As new capital inflows dry up, sellers outnumber buyers, leading investors to question the value and potential of the innovation. The fear of total capital loss sets in, and the price of the asset plummets. In the aftermath, it becomes apparent that many companies and individuals involved in the bubble were overly optimistic or engaged in fraudulent activities.
6. Forget and Repeat
After experiencing the negative consequences of a bubble, investors often vow to never repeat the same mistake. However, financial memory tends to be short-lived, and within a decade or two, investors forget the past and find themselves caught up in another bubble. The pattern repeats itself, and few people keep their promise to avoid future bubbles.
Protection from the Next Bubble
To resist the allure of future asset bubbles, investors can adopt certain principles:
- 1. Resist the Temptation to Cheat Time: Successful investors display patience and understand that investing is a long-term endeavor. Trying to rush the process and seeking shortcuts often leads to dead-ends.
- 2. Prepare to Be Lonely: Recognizing an asset bubble requires going against the prevailing sentiment of the market. Accepting loneliness as a contrarian can be an indicator that the bubble is nearing its end.
- 3. Seek Wisdom from Skeptical and Successful Investors: Buffett and Munger have consistently avoided asset bubbles throughout their careers. Paying attention to their warnings can help investors avoid being caught up in the hype.
- 4. Study Financial History Like It’s Your Job: By studying the history of financial markets and previous bubbles, investors can gain insights into the patterns and red flags associated with bubbles. This knowledge can help in the identification and avoidance of future bubbles.
While asset bubbles are an inherent part of financial markets, understanding their dynamics and implementing these principles can help investors resist the temptation to participate and potentially avoid significant losses.
