Saturday, August 20, 2011
The Investing Dance: Blowing Bubbles while Tip Toeing through the Tulips
Let’s go back in time and to a different Continent. As we design this time machine, we will go back to around the 1630s to Holland-the home of the first recorded Economic Bubble. But before boarding this Delorean, let us look at some things here first. Let us take this quote from the great Economist, Ludwig von Mises:
“He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief; accordingly he will restrict his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding.” (Mises, 1998, p. 423)
As our time machine has landed in Holland, we picture the citizens of Holland speculating on Tulips. The actual pricing is nebulous but, in circa February 1637 the price of Tulips hit their peak; and then dropped precipitously (Wikipedia, 2011). Prior to this drop, people were selling all sorts of possessions just to get their hands on precious tulips and as a result, the hysteria was on! “People selling or trading their other possessions in order to speculate in the tulip market, such as an offer of 12 acres (49,000 m2) of land for one of two existing Semper Augustus bulbs, or a single bulb of the Viceroy that was purchased for a basket of goods (shown at right) worth 2,500 florins." (McKay, 1841).
Soon after the drop took place, it finally ended circa May of 1637--where the estimated price at that point was well below the level predicted earlier that year in February; but at the level predicted November of 1636 (Wikipedia, 2011). The hopes and dreams were gone and vanished. Soon the Dutch were at a point where not one Tulip Bulb could be sold at any price in the winter of 1637 (Sayre, 2011).
As we board our time machine and visit year 2011, we have just seen a similar scenario in the Real Estate market. A countless number of workshops, infomercials, info packages, RE Gurus, etc appeared between in the marketplace between the years 2004-2008. These gurus were experts sent to us to help everyone become wealthy via Real Estate; specifically through flipping houses. Flipping homes is highly speculative venture. Banks were loaning money based on this speculation on the hopes that the prices would increase and the borrowers would pay back at a higher rate of interest.
The Banks were willing to deplete their cash reserves in exchange that this form of speculation would eventually yield a handsome profit. Of course, both the Federal Reserve and the US government made this particularly easy by establishing lower interest rates on the loans. However, similar to the Tulip mania, this too fell down like a deck of cards. The Law of Diminishing Returns and the Economic concept of elasticity do not discriminate. Now in cities, many homes are overbuilt and the vacancy for home inventories increased due to foreclosure, which is parallel to a similar event that took place in the 1600s-the crash of the tulip mania- one can conclude ultimately that the net effects both events are no different.
This same tale can be reviewed in the 1990s with the Tech stock bubble also, or other asset bubbles throughout history. A current tale is brewing with Baby Boomers with their investments inside of 401k type plans, and currently they are seeing great losses as they are approaching retirement.
Of course the current battle cry is investing in Gold, which has its upsides; and also some obvious flaws. Gold is not immune to the aforementioned Economic Principles too. Savvy investors realize this, and have retained most of the Gold reserves waiting for the lemmings to drive up the price more.
How can you protect your hard earned wealth from these types of mania attacks? You must become educated in how the process works. Increasing your financial knowledge base is a starting point, and you should never assume that the price of an investment always goes up in price. All goods and services have the ability to go down in price, especially after a great run has occurred. Right now the Stock Market has hit its low also, so what type of strategy is in play with your 401k plan?
McKay, C. (1841). Extraordinary Popular Delusions and the Madness of Crowds. Unknown: Unknown.
Mises, L. v. (1998). Human Action. Auburn : Ludwig von Mises Institute.
Sayre, H. (2011). The Humanities: Culture, Continuity and Change Volume 2. Upper Saddle River, NJ: Prentice Hall.
Wikipedia. (2011). Tulipmania. Retrieved from http://en.wikipedia.org/wiki/Tulip_mania