The Little Book of Behavioral Investing: How not to be your own worst enemy

Chapter Eleven

This Time Is Different

Your Biggest Advantage over the Pros

 

 

 

 

 

 

PERHAPS THE MOST OBVIOUS AREA of contact that the public will have with behavioral finance, and certainly the most high profile, is the occurrence of bubbles. According to most standard models of finance, bubbles shouldn’t really exist. Yet they have been with us pretty much since time immemorial. The first stock exchange was founded in 1602. The first equity bubble occurred just 118 years later—the South Sea Bubble. Before that, of course, was the Tulipmania of 1637.

At GMO we define a bubble as a (real) price movement that is at least two standard deviations from trend. Now, if market returns were normally distributed as predicted by the efficient markets hypothesis, a two standard deviation event should occur roughly every 44 years. However, we found a staggering 30 plus bubbles since 1925—that is the equivalent of slightly more than one every three years. Not only did we find such a large number of bubbles, but every single one of the them burst, taking us back down two standard deviations. That should happen once every 2,000 years, not 30 times in 84 years! This is the elephant in the room for those who believe in efficient markets.

There is also a view that bubbles are somehow “black swans.” Taleb defined a black swan as a highly improbable event with three principal characteristics:

1. It is unpredictable.

2. It has massive impact.

3. Ex-post, explanations are concocted that make the event appear ...