What is an investment bubble and what does it mean…?

investment bubble

This is a term that we have not used for quite some time, but it is one that we are going to start to use again shortly, with regards to the listed property investment asset class.

An investment bubble is much as it sounds.  A bubble forms when we have a reasonably rapid increase in prices of an asset class, beyond what we would regard as being their true underlying value. The price increase persists for a period of time until the bubble bursts.   When the bubble bursts, the prices deflate rapidly, and it takes quite a period of time for the asset class to regain any equilibrium and for a stable market value to be re-established.

From an academic perspective, there is no real theory for what causes investment bubbles to form.  Sometimes it is greed, and other times, it is because of need.  I believe that this is what we are starting to see now.     At the moment, interest rates are at historic lows globally.  Investors who are relying on portfolio income to support their retirement are looking for ways to generate income.    The New Zealand sharemarket has a culture of paying high dividends on shares (6% – 8% average).  The high rise in the value of the NZ sharemarket –  the NZX50 gross with imputation credits benchmark returned 30.84% for the year to 31 January 2013 – may have partially been driven by people looking for returns.   The same applies with listed property trusts, which often pay between 8% – 10% dividends.

Investment bubbles are not a new phenomenon.  The first recorded investment bubble occurred between 1711 and 1720 with the British South Seas Shipping company.  This was a business where the shares were publicly sold to fund the company.  The company was granted the sole rights to trade with South America at that time.  However, the Spanish controlled South America and they were not amenable to trading with the British at that time.  The South Seas Shipping company was one of many new businesses that were touting for public investment at the time. It is recorded that one such company was floated with the following statement:  “a company for carrying out an undertaking of great advantage, but nobody to know what it is”. This company was promising returns of 100% per annum.


South Seas Share Certificate

A South Seas share certificate – source: www.stock-market-crash.net

The interesting thing about the South Seas Shipping Company case study for me is not the logistics of what happened, but how people reacted to the bubble phenomenon, including incredibly intelligent thinkers.  Many of the investors were peers of the realm, and members of Parliament, but one investor of phenomenal intelligence was Sir Isaac Newton.  Sir Isaac was an English physicist and mathematician, who is arguably most famous for his work on the laws of motion and gravity.  He also built the first reflecting telescope, and was a Master of the Royal Mint, in charge of making coins for the Government.   Sir Isaac was one of the early investors in the South Seas Shipping Company and sold his shares as the prices soared. He made a £7,000 profit, which was 100% return for him.  However, as the prices continued to rise, he then bought more shares almost at the peak of the prices and then lost £20,000 pounds when the bubble burst.  £20,000 would roughly be the equivalent of $5 million US dollars today – that’s a fortune by anyone’s standards.


South Seas Share Prices 1719-1721

South Seas share prices 1719-1721

Source: Wikipedia

Sir Isaac Newton’s comment following the demise of the South Seas Shipping Company:

Sir Isaac Newton

Just prior to the demise of the South Seas Shipping company, a piece of legislation was passed by the British Government called “the Bubble Act 1720”. The Act forbade any companies from raising funds by selling shares unless the company had been authorised by Royal Charter.    This is where the term “investment bubble” as originated from.  This legislation was designed to deter the large number of speculative companies that were being established at the time.

The main lesson to be learned with investment bubbles is to not let your heart rule your head.  It does seem crazy to be selling investments that are producing phenomenal returns, and there is a natural tendency to try and hang in there as long as you can to play “chicken” with the bubble.  However, the logical process is to gradually sell down your investment over a fixed period of time, which means that you are still getting some returns from the asset class but are also reducing your exposure to it.   The rule of thumb that we adhere to is to sell out over a 2 year period.  No-one can actually predict with any accuracy when a bubble will burst, even Sir Isaac Newton.  The only certainty is that it WILL burst, and that you do not want to have “all of your skin in the game” when it does!