Financial Advice for My Son


Speculative Bubbles

Roughly every 10 years, human nature causes "tulipmania", a disease where people become convinced that they are in on the discovery of the century, that previous market rules or guidelines no longer apply, and that money can be made hand over fist by anyone with no thought. The speculation is that it takes about 10 years for humans to forget their vow never to put their money in such an "investment" again!

The power of such bubbles is demonstrated by the experience of Sir Isaac Newton, of applies and gravity fame. I need to look up the exact details, but the story goes roughly as follows. Sir Isaac owned some stock in some company (South Sea Trading Company?) when a run-up in its price began occurring. When the price had appreciated a certain amount, Sir Isaac sold all his stock and congratulated himself on getting out before the inevitable crash. About one year later, when the bubble was building to its height, Sir Isaac got caught up in the speculation and spent several times more money in purchasing shares. Shortly thereafter, the crash occurred and he lost almost all his money invested in that stock!

Examples of such bubbles:

- 1926 stock market run-up and crash.

- 1987 stock market run-up and crash.

- 1977-1979 Southern California rental property run-up, which was unusual in that it was not followed by a crash. Instead, a "soft landing" occurred, with property prices remaining flat for 5 years.

- 1980 gold and silver run-up and crash.

- 1980s lending boom to Third World Countries, where money-center banks were making money hand-over-fist in loaning incredible sums at high rates to countries that could not have a hope of repaying their debts.

Many people feel that the Japanese stock market is in the midst of a speculative bubble, with people intently hunting for new reasons to justify its incredible run-up.

See the book "Manias, Panics, and other Financial Crises" for more details.

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