For some reason, we humans seem to repeat some mistakes over and over again. From the sensational growth in the price of tulip bulbs in the 17th century to the dot com boom, we get caught up in the prospect of big returns and forget that the underlying asset hasn’t changed in value, or at least not by that much.
To help explain why you should care about this, I need to provide some foundational information.
For the purpose of our discussion, there are two ways to value an asset
- Economic Value – The price corresponds to or is correlated to the economic value that the asset provides. For example, a stock price of $100 is based on financial analysis that says earnings are sustainable and warrant such a price.
- Emotional Value – The price is a result of what we believe the asset is worth. Basically, I’m willing to pay $100 for a Tickle Me Elmo because we shoppers decided that it’s a must have item.
The Emotional Investment Cycle
I once saw an illustration depicting how many common investors operate. Basically, as a stock price rises, research heavy investors such as large banks invest. The price continues to rise. Common investors then begin to hear about it and jump on the bandwagon. The majority of common investors hear about the now “hot stock” as it is reaching its peak (inflated from everyone jumping on board). You then invest, watch the stock rise momentarily, and then see it fall. You either break-even or take a loss. The reason you made the investment was because of the emotion that surges around a hot stock tip and the hope that you can cash in.
Upon hearing the hot tip, you should have spent time investigating the underlying value of the asset (in this example, the company).
I personally have fallen into this trap, ignored the red flags telling me to dig deeper, and ended up losing money.
Examples of Bubbles
The Housing Bubble: I listened once as a banker described how the housing market grew and crashed. Banks believed that (1) housing prices always rise and (2) Americans will never default on the American dream – owning a home. So banks knowingly overvalued homes and over-lent. Consumers were all too happy to accept the overvaluations and extra cash. There was nothing to indicate that homes were actually worth that much other than the fact that we said so. The result – economic meltdown.
The Dot Com Era: Small Internet start-ups launched websites that began to generate traffic, though not necessarily revenue. Angel investors funded the start-ups until they were taken public through an IPO. Often, the IPO happened only a short time after the company began (meaning, no proven track record of earnings). Seeing easy money, many Internet companies rushed to the feeding trough. Amazingly, investors bought shares of companies that had no economic model or revenue history. The result – economic meltdown.
Is Social Media the Next Bubble?
A recent article on MediaPost.com related statements from Warren Buffett and Barry Diller warning that social media may become another bubble with many losers.
Buffett said, “Most of them will be overpriced… It’s extremely difficult to value social-networking-site companies.” Diller described the huge valuations of companies like Groupon as, “mathematically insane.”
I’m not an expert. But I do understand that a price based on an emotional valuation will fail. I also take great comfort in the fact that the Oracle of Omaha seems to agree with me. Or maybe it’s me agreeing with him (I don’t want to take too much credit).
As social media companies begin to go public, I can see the headlines alone driving an investment frenzy that will cost many common investors dearly. That is not to say that social media companies can’t or won’t make money for them and investors. My point is that you need to consider the financials of the company and environmental factors (or factors outside of the company) to determine whether or not the investment is a good prospect for inclusion in your portfolio or just another bubble that will burst your nest egg.
Maybe you wouldn’t typically consider the US dollar a bubble. But it’s certainly traded like any other asset, so why not? Right now, our government is printing dollars at an alarming rate. What’s holding up the value of each one of those dollars? The belief that the government can back it.
So going back to the two valuation models above, is the value of a dollar based on the economic value or the emotional value? Well, Gross Domestic Product (GDP) fell from 2008 to 2009 and yet we added approx. $3.1 trillion in debt over those same two years. So we are printing more and turning out less. That relationship may be manifesting itself in the poor exchange rate between the dollar and other currencies such as the euro.
Basically, the dollar and everything tied to it (e.g. inflation, exchange rates) is subject to the same risks as any other investment if it rides up too high based on emotional value (e.g. exorbitant healthcare bills).
In fact, Standard & Poor’s issued a warning to the U.S. government just yesterday that the government’s triple A rating may be downgraded if the government deficit is not addressed quickly.
If you are concerned about the underlying value of the dollar, then write your representative or just vote a new one into office. Political change is like rebalancing an unbalanced investment portfolio.
Before jumping on the next hot trend…
Stop and ask yourself, “What economic or financial value does this asset create? And will it continue to create that value while I have it or invest in it?”