Examples of asset bubbles that kept growing and popped spectacularly
Bitcoin is going through another spectacular price move so far in 2021, rising from about $28,000 on January 1st to about $48,000 in mid-February. And other cryptocurrencies have come along for the ride, with Dogecoin (pronounced “dozhe-coin”), being one of the oddest of the bunch.
Why is it odd? Well, Dogecoin was originally a joke cryptocurrency, taking its name from the “doge” internet meme that showed a picture of a Shiba Inu dog talking in Comic Sans font.
Dogecoin Was Created in 3 Hours
Dogecoin was created for fun and the idea was to have a goofy cryptocurrency that was cheap enough – each coin was worth a fraction of a penny – so that fans could “tip” each other for amusing comments. Think of it as a Facebook “like” that has some monetary value, but the value is so ridiculously low that no one took it seriously. In fact, if you look at the “value” of a dogecoin, it hovered right around 1/5 of a penny – in other words, five dogecoins equaled one penny for most of its existence.
But then on January 28th, a Twitter user called WSBChairman (who claimed no affiliation with /r/wallstreetbets, the same Reddit sub-group of users that pushed GameStop to ridiculous heights), tweeted that dogecoin was the next potential asset to get behind. The price skyrocketed the very next day so that a single dogecoin was now trading at 7 cents. Then Elon Musk tweeted about it and it hit 8 cents. And as of February 11th, dogecoin was trading close to that 8 cents level.
Billy Markus, the guy who spent about 3 hours making Dogecoin, posted an open letter on Reddit on February 8th. His letter is a fascinating read, as he urges the community to get back to the spirit of fun. But his closing remarks are ones that all investors should heed when he wrote:
“Keep educating yourself as much as you can on how cryptocurrency works, how these markets work, never risk more than you could safely lose, be vigilant and aware.”
Cryptocurrencies as an Investment?
If we open our history books, we can read about major occasions where the market fell or rose dramatically. Markets can (and do) rise, of course, due to strong economies. These are good market booms.
However, sometimes there are market bubbles, the unreasonable market booms. Bubbles occur when investors pour money into a specific stock or market segment, way beyond the actual value of the particular businesses and products.
“Asset euphoria” has been used to describe investor interest in a bubble stock or sector. Like soap bubbles, investing bubbles keep growing but eventually pop because there is nothing substantial holding them up.
If you are considering cryptocurrencies as an investment, keep this in mind: the only way to make money from a cryptocurrency is to sell it to someone else for more money. And the only way they can make money is to sell it on to someone else for even more. And so on and so on.
Here are some more historical examples that fit the classic definition of “asset euphoria” and might even sound eerily similar to dogecoin:
Tulip Bulb Mania (Holland, 1630s)
Holland’s upper classes competed for the rarest bulbs, after tulips had become a status symbol. Tulip bulbs were then traded on Dutch stock exchanges, so all members of society were encouraged to speculate on them. At the height of the market, tulip bulbs traded for several times the average Dutch annual salary. However, tulip bulb prices eventually dropped. Panic selling set in, which left many investors in ruin.
Mississippi Company (France, 1719-1720)
The French economy was in dire straits, and the national debt was restructured under the auspices of the Mississippi Company, which was given exclusive trading rights for the various French colonies. Numerous continental traders rushed to buy shares in the Mississippi Company and soon the stock was worth 80 times as much as all the gold and silver in France, so the French government could not cover its debt (the shares in the company). The value of the shares plummeted, and investors took huge losses.
Dot.com Bubble (2000-2002)
The excitement of the internet, with its promise of an international market for goods and fascinating new ways of communication, overwhelmed many investors. Investors blindly bought newly issued stock from the IPOs of internet companies as their stock prices zoomed upward. Unfortunately, these investors never bothered to look over the companies’ business plans. Unable to actually make money, many of these internet companies reported huge losses and folded (Pets.com, Boo.com and Webvan come to mind).
Housing and Mortgage Crisis (2007-2009)
Rising home prices led to rampant real estate speculation and a housing boom. This housing boom and low interest rates led many lenders to offer home loans to people with poor credit. Investor firms bought these loans, then sold them as mortgage-backed securities to large investors. When payments began to catch up with home buyers who could not afford them, foreclosures jumped dramatically, which led to enormous losses by banks and investment firms that traded in these mortgage-backed securities. Many people lost their homes, and many banks lost lots of money. This led to a global credit crisis.
How Could Investors NOT See These Things Happening?
How could this “asset euphoria” have continued? It is obvious to us now why the busts happened and what we would have done differently, had we been there. However, even the wisest investors found it difficult to imagine the massive problems that would develop. We can quantify, analyze, and monitor market trends, but we cannot predict the future. All that investors (and we as their advisors) can do is to be ready for changes in the market, whether mild or massive.
Preparing for the Booms and the Busts
How does a wise investor prepare to enjoy any booms and protect against any busts?
To avoid falling prey to the lure of “asset euphoria,” as seen with the bubbles described above, remember the adage: “If it sounds too good to be true, then it probably is.”
To avoid losing large amounts of money due to market changes, the best move is to diversify your holdings. Diversifying your assets among various types of investments allows you to get a better risk-adjusted return. You spread the risks around. This is a major pillar of our investment philosophy at Patriot. If you need help balancing your investment impulses and diversifying your holdings properly, reach out to us and we’ll be happy to help.