Bubbles, Sentiment, and Narratives

Why this matters

This optional lesson looks at the most extreme version of crowd behavior: the bubble. Bubbles are rare, but they do lasting damage, especially to investors who arrive late and in size. Understanding how they work won't let you predict one, but it can stop you from betting your future on one.

How a bubble forms

A bubble can start with something real: a new technology, a genuine change in an industry, a period of strong growth. Rising prices then draw in buyers who are buying mainly because prices are rising. The SEC-commissioned report on investor behavior describes this kind of momentum investing as a form of herd behavior that can give rise to speculative bubbles, such as the dot-com bubble of the late 1990s.¹

A narrative holds it together: a story about why old ways of valuing businesses no longer apply. Sentiment, the overall mood of investors, turns from optimism to euphoria. Then something punctures the story, and the same forces run in reverse.

Prices swing more than fundamentals

In awarding the 2013 Nobel Prize in economics, the prize committee described Robert Shiller's finding that stock prices fluctuate much more than corporate dividends, and that the ratio of prices to dividends tends to fall when it's high and rise when it's low. It noted that the pattern holds for bonds and other assets too.²

That's why valuation matters most at extremes. When prices are very high relative to what businesses pay out and earn, the gap has historically tended to close, though not on any predictable schedule. Part 4's Price vs. Value covered why the two can drift apart.

Case study: the dot-com bubble

In the late 1990s, the internet was a genuinely transformative technology, and the story of a "new economy" seemed convincing. The Nasdaq Composite, an index heavy in technology companies, closed at 5,048.62 on March 10, 2000. By October 9, 2002, it had fallen to 1,114.11, a decline of about 78%. It didn't close above its 2000 peak again until April 23, 2015.³

The internet did change the world. But being right about a technology isn't the same as being right about the price. Investors who bought the index at its peak waited 15 years to break even, before dividends.

The rest of this lesson is for members

Still to come in this lesson: Questions worth asking, Defenses that don't require predictions, the key takeaways, and 2 quiz questions with explanations.

Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.

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