I’d rather use a more powerful EMH-focused definition: a bubble is large price increase which represents an inefficiency in the market which is predictable in advance (not in hindsight), exploitable, and worth exploiting.
I’m happy with that definition. EMH (Efficient Market Hypothesis) for those of you following along at home.
In my case I had amassed a small fortune by October of 1999 by simply holding the stock options I had been granted on taking the job 4 years earlier. They were up more than 10X at that point. Actionable? My very intelligent college roommate owned his own financial advising firm. He spent two weeks on the phone with me convincing me that it would be gigantically more sensible to cash out these options and give them to him to invest “in case, in the future, people get up in the morning, put their clothes on, and go outside instead of sitting in front of their PCs all day ordering stuff off the internet.” He sent me books to read including this one first published in 1841. This describes witch hunts as well as South Sea, Tulip and other financial bubbles. Jim, my roommate, had been referring to tech as a bubble for a year or two before I talked to him in October of 1999. The action he was taking with his other clients was to simply not get in to tech. This was a horribly unsatisfying strategy until about the middle of 2000 when tech was well into its slide from the top.
By the time I cashed out and handed him the money in about december 1999, the stock had more than doubled again. The human in me wanted to hold on to it because, obviously, this was a stock which kept on doubling. He explained to the rationalist in me that whatever the case for investing that money in something else was at half the price, the case was TWICE as good at twice the price, unless we had learned something quite important and positive about the business in the last two months. Which we hadn’t of course. What we had learned is that there was no shortage of “greater fools” willing to buy in AFTER all that price appreciation had already happened on old information that was not changing nearly as fast as the price.
Over the next three years the stock I had sold in December 1999 gave back about 75% of its price gains. Meanwhile, my friend invested my money in REITs, Berkshire Hathaway, banks, and a bunch of other asset classes not even dreamed about by most of my fellow techies. The money I had given him grew by 40% more or less, I don’t remember exactly, while the nearly half of my original stock grant I had kept in my employers stock contracted to 20% of its peak value.
So yes, to me the internet bubble appears to have been actionable before it burst. The “investors” who stayed with the bubble, myself included with what started out as nearly half of my fortune and ended as about a tenth of it. The shift of 60% of my money out of the bubble preserved my wealth at a level that may well have been unique among my peers at this company.
I realize you can’t get a drug approved with this kind of evidence. But you realize that most of what we “know” is the best model we can come up with in the absence of double blind studies. I’ve detailed the one best example in my life. I agree it is HARD to act on bubbles, shorting them is scary and fraught with risk, you are betting you can stay solvent longer than the market can stay stupid, which is quite a bet indeed. So bubbles, so spectacularly obvious in retrospect, may be no more reliably useful for making money than is any mispricing, even smaller more temporary ones.
Out of curiousity, are you enough of an EMH’er that you don’t believe in mispricings? Or at least not in publicly traded financial securities markets? Do you think it is just a roll of the dice that 9 students of Ben Graham all ran funds which had long term returns above market averages? I think a bubble is just a particular kind of mispricing, a particular kind of inefficiency. It may be no easier to exploit than the other kinds of mispricings, but it is probably not harder to exploit. And shorting is not the only way to exploit bubbles or mispricings, just sticking with a discipline which on average avoids them appears to work for a broad range of investors, including such low-entropy categories of investors as former students of one professor who espoused value investing.
Actionable? My very intelligent college roommate owned his own financial advising firm. He spent two weeks on the phone with me convincing me that it would be gigantically more sensible to cash out these options and give them to him to invest “in case, in the future, people get up in the morning, put their clothes on, and go outside instead of sitting in front of their PCs all day ordering stuff off the internet.”
This actionable advice is also 100% justifiable without recourse to claims of superior perception simply by the high value of diversification. Keeping a large sum of money in a single stock’s options is really risky, even if you think it’s +EV, and even if you think some EMH conditions don’t apply (you had insider knowledge the market didn’t, the market was not deep or liquid, you had special circumstances, etc). Same reason I keep telling kiba to cash out some of his bitcoins and diversify—I am bullish on Bitcoin, but he should not keep so much of his net worth in a single volatile & risky asset.
He sent me books to read including this one first published in 1841.
MacKay is not the most reliable authority on these matters, you know. The book I mention punctures a few of the myths MacKay peddles.
Jim, my roommate, had been referring to tech as a bubble for a year or two before I talked to him in October of 1999. The action he was taking with his other clients was to simply not get in to tech. This was a horribly unsatisfying strategy until about the middle of 2000 when tech was well into its slide from the top.
An anecdote, as you well realize. You recall the hits and forget the misses. How many other bubbles did Jim call over the years? Did his clients on net outperform indices?
Meanwhile, my friend invested my money in REITs, Berkshire Hathaway, banks, and a bunch of other asset classes not even dreamed about by most of my fellow techies. The money I had given him grew by 40% more or less, I don’t remember exactly
And would have grown by how much if they had been in REITs in 2008?
I agree it is HARD to act on bubbles, shorting them is scary and fraught with risk, you are betting you can stay solvent longer than the market can stay stupid, which is quite a bet indeed.
It’s not just that you’re betting that you can stay solvent longer, you’re betting that you have correctly spotted a bubble. There was a guy on the Bitcoin forums who entered into a short contract targeting Bitcoin at $30. Last I heard, he was upside-down by $100k and it was assumed he would not be paying out.
Do you think it is just a roll of the dice that 9 students of Ben Graham all ran funds which had long term returns above market averages?
As a matter of fact, someone a while ago emailed me that to try to argue that EMH was false. This is what I said to them:
A cute story from long ago, but methinks the lady doth protest too
much—he may say he has not cherrypicked them, but that’s not true:
the insidious thing about datamining and multiple comparison is that
there’s nothing false about the results, if you slice the data
such-and-such a way you will get their claimed result. And even if
there are no other employees or contractors or students quietly
omitted and we take everything at face value, he hasn’t shown that
they aren’t counted in the coin-flipping orangutans given a loaded
coin producing 7% returns a year. Why aren’t his former coworkers
giving away dozens of billions of dollars? If they were beating 7%
like he says they were, they should—in 2012, 28 years later—be
sitting on immense fortunes. Buffett himself seems, these days, to
generate a lot of Berkshire profit just from being so big and liquid,
in selling all sorts of insurance and making huge purchases like his
recent railway purchase.
I don’t think that even begins to overturn efficient markets, sorry.
Out of curiousity, are you enough of an EMH’er that you don’t believe in mispricings? Or at least not in publicly traded financial securities markets?
Pretty much. I believe in inefficiencies in small or niche markets like Bitcoin or prediction markets, but in big bonds or stocks? No way.
It may be no easier to exploit than the other kinds of mispricings, but it is probably not harder to exploit.
I have watched countless people, from Paulson to Spitznagel to Dr Doom to Thiel, lose billions or sell their companies or get out of finance due to failed bets they made on ‘obvious’ predictions like hyperinflation and ‘bubbles’ in US Treasuries since that housing bubble which they supposedly called based on their superior rationality & investing skills. It certainly seems like it’s harder to exploit. As I said, when you look at complete track records and not isolated examples—do they look like luck & selection effects, or skill & sustained inefficiencies?
I heartily endorse this analysis. I would recommend actually the original paper rather than the review of that paper cited by gwern.
At no point that I could find in this paper did they find that they needed to appeal to luck or random outlier quality to explain Buffett’s performance. Indeed, except that it is decades after the fact, it seemed fairly simple for them to explain Buffett’s performance quantitatively from picking stocks that the author’s say systematically outperform the market, sticking with his method of picking stocks in good and bad times for his portfolio or the market as a whole, and in using a moderate amount of leverage, they estimate about 1.6.
Not rocket science, not snake oil, and not a long sequence of lucky coin-flips.
I’m happy with that definition. EMH (Efficient Market Hypothesis) for those of you following along at home.
In my case I had amassed a small fortune by October of 1999 by simply holding the stock options I had been granted on taking the job 4 years earlier. They were up more than 10X at that point. Actionable? My very intelligent college roommate owned his own financial advising firm. He spent two weeks on the phone with me convincing me that it would be gigantically more sensible to cash out these options and give them to him to invest “in case, in the future, people get up in the morning, put their clothes on, and go outside instead of sitting in front of their PCs all day ordering stuff off the internet.” He sent me books to read including this one first published in 1841. This describes witch hunts as well as South Sea, Tulip and other financial bubbles. Jim, my roommate, had been referring to tech as a bubble for a year or two before I talked to him in October of 1999. The action he was taking with his other clients was to simply not get in to tech. This was a horribly unsatisfying strategy until about the middle of 2000 when tech was well into its slide from the top.
By the time I cashed out and handed him the money in about december 1999, the stock had more than doubled again. The human in me wanted to hold on to it because, obviously, this was a stock which kept on doubling. He explained to the rationalist in me that whatever the case for investing that money in something else was at half the price, the case was TWICE as good at twice the price, unless we had learned something quite important and positive about the business in the last two months. Which we hadn’t of course. What we had learned is that there was no shortage of “greater fools” willing to buy in AFTER all that price appreciation had already happened on old information that was not changing nearly as fast as the price.
Over the next three years the stock I had sold in December 1999 gave back about 75% of its price gains. Meanwhile, my friend invested my money in REITs, Berkshire Hathaway, banks, and a bunch of other asset classes not even dreamed about by most of my fellow techies. The money I had given him grew by 40% more or less, I don’t remember exactly, while the nearly half of my original stock grant I had kept in my employers stock contracted to 20% of its peak value.
So yes, to me the internet bubble appears to have been actionable before it burst. The “investors” who stayed with the bubble, myself included with what started out as nearly half of my fortune and ended as about a tenth of it. The shift of 60% of my money out of the bubble preserved my wealth at a level that may well have been unique among my peers at this company.
I realize you can’t get a drug approved with this kind of evidence. But you realize that most of what we “know” is the best model we can come up with in the absence of double blind studies. I’ve detailed the one best example in my life. I agree it is HARD to act on bubbles, shorting them is scary and fraught with risk, you are betting you can stay solvent longer than the market can stay stupid, which is quite a bet indeed. So bubbles, so spectacularly obvious in retrospect, may be no more reliably useful for making money than is any mispricing, even smaller more temporary ones.
Out of curiousity, are you enough of an EMH’er that you don’t believe in mispricings? Or at least not in publicly traded financial securities markets? Do you think it is just a roll of the dice that 9 students of Ben Graham all ran funds which had long term returns above market averages? I think a bubble is just a particular kind of mispricing, a particular kind of inefficiency. It may be no easier to exploit than the other kinds of mispricings, but it is probably not harder to exploit. And shorting is not the only way to exploit bubbles or mispricings, just sticking with a discipline which on average avoids them appears to work for a broad range of investors, including such low-entropy categories of investors as former students of one professor who espoused value investing.
This actionable advice is also 100% justifiable without recourse to claims of superior perception simply by the high value of diversification. Keeping a large sum of money in a single stock’s options is really risky, even if you think it’s +EV, and even if you think some EMH conditions don’t apply (you had insider knowledge the market didn’t, the market was not deep or liquid, you had special circumstances, etc). Same reason I keep telling kiba to cash out some of his bitcoins and diversify—I am bullish on Bitcoin, but he should not keep so much of his net worth in a single volatile & risky asset.
MacKay is not the most reliable authority on these matters, you know. The book I mention punctures a few of the myths MacKay peddles.
An anecdote, as you well realize. You recall the hits and forget the misses. How many other bubbles did Jim call over the years? Did his clients on net outperform indices?
And would have grown by how much if they had been in REITs in 2008?
It’s not just that you’re betting that you can stay solvent longer, you’re betting that you have correctly spotted a bubble. There was a guy on the Bitcoin forums who entered into a short contract targeting Bitcoin at $30. Last I heard, he was upside-down by $100k and it was assumed he would not be paying out.
As a matter of fact, someone a while ago emailed me that to try to argue that EMH was false. This is what I said to them:
Speaking of Buffett’s magical returns, I found http://www.prospectmagazine.co.uk/economics/secrets-of-warren-buffett/ interesting although I’m not competent to evaluate the research claims.
Pretty much. I believe in inefficiencies in small or niche markets like Bitcoin or prediction markets, but in big bonds or stocks? No way.
I have watched countless people, from Paulson to Spitznagel to Dr Doom to Thiel, lose billions or sell their companies or get out of finance due to failed bets they made on ‘obvious’ predictions like hyperinflation and ‘bubbles’ in US Treasuries since that housing bubble which they supposedly called based on their superior rationality & investing skills. It certainly seems like it’s harder to exploit. As I said, when you look at complete track records and not isolated examples—do they look like luck & selection effects, or skill & sustained inefficiencies?
I heartily endorse this analysis. I would recommend actually the original paper rather than the review of that paper cited by gwern.
At no point that I could find in this paper did they find that they needed to appeal to luck or random outlier quality to explain Buffett’s performance. Indeed, except that it is decades after the fact, it seemed fairly simple for them to explain Buffett’s performance quantitatively from picking stocks that the author’s say systematically outperform the market, sticking with his method of picking stocks in good and bad times for his portfolio or the market as a whole, and in using a moderate amount of leverage, they estimate about 1.6.
Not rocket science, not snake oil, and not a long sequence of lucky coin-flips.