Rational bubbles

According to Dean Takahashi

Can you feel the froth? Investment in U.S. venture-backed companies rose 35 percent in the first quarter, according to a report by Dow Jones VentureSource. Venture firms invested $6.4 billion into 661 deals in the U.S. during the quarter.

According to Peter Coy and Roben Farzad in “The Granddaddy of All Bubbles?

Didier Sornette, a physicist who studies finance at the Swiss Federal Institute of Technology Zurich, sketches out six stages of bubbles: 1) the appearance of a new investment opportunity; 2) the expansion of credit; 3) euphoria; 4) distress; 5) revulsion; 6) panic. Ventura and Martin don’t even assume euphoria. In their “rational bubbles,” investors buy into a bubbly asset because they conclude that the overpricing can last for many years, and the chance they will still be invested when the bubble bursts is small. For all the people who sell before the bust, as well as all those who earn salaries from the sector while it’s still bubbling, there’s no downside, they note.

Back in 2009, I was wondering “how to profit safely from economic bubbles“.

Now seems like a good time to start thinking of moving out of commodities and equities and into cash. Maybe there are still some rational bubble peaks to be climbed, but I’m feeling a touch of altitude sickness.

Ferris Wheel, Plage du Prado, Marseilles

According to this, the best performing stock mutual fund of the last decade racked up an amazing annual growth rate of 18%, yet its average investor lost at an annual rate of 11%. Why? — because the fund was volatile, and people invested when it was hot, and sold when it was not. Rationally, if you know the prices in a market are volatile, you ought to buy when they’ve gone down for a while, sell when they’ve gone up for a while. Easier said then done, I’m sure, because human nature tempts us to do the opposite.


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