This is the first blog of the Share the Wealth series, which will discuss various investment theories and principles. The goal of this series is to make you, the reader, more aware of different investing strategies and potentially help you decide if the strategies can be made applicable to your own portfolio. SprinkleBit is on your side and we want to supply you with as much information as possible.They say a greater fool is born every day, Sprinkle Nation, and you can bet we don't want this to happen to you! So heed this cautionary tale, lest history repeats itself! Before the housing bubble of 2008, there was "Tulipmania." Named for the rampant speculation of bulbs that produce the delicate tulip flower, the movement was started after tulip bulbs were introduced to Amsterdam in the 1630s. They were deemed very valuable for their novelty and short bloom time. From the dank wharfs of Dutch merchant ports, to lavish sitting rooms of French design, speculators in the 1630s bartered and traded their life savings away in the hopes of finding speculative buyers willing to pay an even higher price. The price of tulip bulbs went up and up and up until speculators were trading single bulbs for the price of an expensive home. In 1636, when the price of the bulbs were so high as to dissuade more buyers, effectively bursting the tulip boom bubble, many foolish speculators found themselves with worthless investments for which they had grossly overpaid. Tulipmania is often cited as the first recorded example of an economic bubble—of unchecked speculation driving the price of an item up and up until the price greatly exceeds the value of the item being traded.
How do Market Bubbles Occur?Bubbles and speculation occur in part because of a characteristic investor whom economists refer to as the "Greater Fool." The Greater Fool theory is the idea that a sucker is born everyday. Unfortunately, for many investors who lack a support network from which to learn to spot overvalued (overpriced) stocks, there are those less-savory investors who may exploit this strategy to benefit from the naive among their ranks—those "greater fools" willing to buy their stock from them at a higher price. Investments such as stocks, bonds and real estate have an intrinsic value tied to them, but value can be swayed by hype, emotions and rumors! Greater Fool buying and selling tends to occur in short-term market periods, where trends change quickly and rumors fuel trading. These short-term market periods, also known as market bubbles, can be characterized by periods in which investors buy assets in large volumes and then (attempt to or hope to) sell them at inflated prices. Do you remember the Dot Com bubble of 2000? Or the housing bubble of 2008? Or how about something even more recent? Take the Facebook IPO (FB) for example. The Facebook IPO, as it turns out, was overvalued by underwriters (although that's also another story), and unfortunately, retail investors who gambled on the hype surrounding the IPO lost about $630 million when the price dropped to its truer value only weeks later. Today, in October 2012, investors still await the day when Facebook proves itself to be working towards proving its long-term investment potential. It's one thing to operate a site that over 1 billion people use, but the savvy investor knows that it's an entirely different thing to monetize that site, and that facebook is still struggling with a plan for monetization. Wise investors look for evidence of long-term company growth, and they consider the whole picture before jumping on a hyped IPO. They don't listen to the hoopla or let excitement color their judgement. If those sorry retail investors back in May had asked themselves to list the strategies that Facebook has demonstrated as proof of their revenue potential, they would have seen that Facebook's current plan didn't hold water just yet—and happiest of all, there would have been fewer fools losing money out of the gate.
Sprinkle Nation, Don't be the Greater Fool!Financial literacy, crowdsourcing stock information and leveraging your network of investors will help you stay grounded and patient, waiting for the dust to settle after tempting news announcements. Then you will be ready to make a clear-headed, more informed investment decision. If another investor has a stronger emotional attachment to the company or strongly believes that there is a lot more money to be made from the asset, then he or she will be willing to pay the higher price—not you. In due time, the true market value of the stock will reveal itself and you will find out soon enough whether the asset you've been eyeing is worth the investment.
The Temptation Can Be Great, But Take CareIf there is increased media attention, when many people are buying and it’s said to be a “sure thing”, then you can assume that the stock you’re following is most likely a bubble. Even though entering these markets can be risky, many people choose to do so anyway. If this sort of risk is what you’re interested in then make sure to evade the pitfall of being the Greater Fool. It takes a savvy investor to know how to avoid being the Greater Fool. A simple way to not suffer a loss is to remove all emotion from your investing and instead focus on basic investment advice:
- Do your homework! The key to making any knowledgeable investment decision is to first do your research on the industry and company in which you would like to enter.
- Diversify your portfolio by investing in multiple industries. You have the power to innoculate your portfolio from unsystematic risk; diversifying your investments is the way to do so. Use the power of multiple portfolios, Sprinkler!
- Tip-toe through the tulips, don't rush in headlong with your checkbook out. The Greater Fool Theory is mainly concentrated in market bubbles, so if you focus on research and long-term investing strategies, you'll be less likely to be taken up in the "next" Tulipmania.
- There’s no need to make rushed decisions. There will always be opportunities in the stock market for you to take advantage of. Be patient, because another opportunity is sure to be around the corner.