Monday, July 25, 2011

Bubbles aren't just a toy for children

In order to have a market it is necessary to have people. Whenever you have a large group of people it is necessary to understand psychology. If I am sitting at my desk, and I hear from one of my friends that they just saved a ton of money by switching their car insurance to a different carrier what would my first reaction be? I would be on the phone calling that carrier to change my own car insurance without even looking at how much the new carrier is charging (if I was like most people). Retail investors are no different. If someone hears that so-and-sos uncle just made 50% in two weeks by investing in some small bio-tech company then this person is likely to go invest a large amount of money in bio-tech stocks (that he or she likely knows nothing about). This is relatively harmless to the overall market (though very often particularly harmful to that individual investor), the problem is when this process occurs with a popular idea that is somewhat unique. If everyone wants to get a piece of the popular idea, despite an ever growing valuation, eventually there will be a tipping point. The saying goes like this "If you pull up to the gas station and the attendant tells you that you should buy xyz company stock, then you know it's time to sell xyz company stock". This is Scenario 1.

Now lets say that we have one very successful unique idea (similar to scenario 1), but now 10,000 people copy your idea. Everybody wants a piece of the original idea (that is very successful), but unfortunately there are not enough equity shares to go around. Instead of sitting idly by and missing out on that great market (and lots of supposed profit) people start investing in the knock off sites. As the valuation of the original site increases so does the valuation of the knock offs. Eventually there are so many knock off sites that the market is flooded and valuations of all sites (including the original) deflate. This is Scenario 2.

Lastly lets say that you are entering a charity raffle for a brand new 60 inch tv (msrp $2500 lets assume unkown to the members). The raffle tickets are $1 each and you buy 10 figuring you will take a shot. The organization has 1000 members and each member besides you buys 5 tickets. The organization looks at the money generated 3 days before the raffle and is a little disappointed so they try to come up with a way to increase their revenue. A wise board member suggests selling the raffle tickets as buy 1 get 1 free for the last 3 days until the raffle will end and a winner is picked.
     Now for the next raffle lets complicate matters and say that you have 2 choices when you buy your raffle tickets. You can either buy the original tickets for $1 a piece or you could buy coupons for a meal (burger, fries, and soda) at a local burger joint for $4 (a $3 discount). Let's say that there is a finite but large amount of these burger coupons and an finite amount of raffle tickets to be sold. As you could probably guess most of the members of the charity decided they weren't going to be a fool again so they bought the burger joint coupons. They not only bought coupons for themselves they also made the business decision of buying extra tickets so they could sell them to other people. This model seems to work great at first as the market seems to be willing to pay $5.50 for these coupons. The charity is making money, the charity members (reselling) are making money, and the people buying the coupons from the members are making money. One day the restaurant catches wind of what the charity members are doing and decides to run a $5.00 meal promotion until the coupons expire. The secondary market for the coupons goes from $5.50 to $4.00 overnight, and what's worse is that the charity members bought so many coupons they don't know what to do with them. The next day charity members start panicking and sell the coupons for $3.50... $3.00... $2.50.  This is Scenario 3

End Note:  Obviously if you follow investment news on a somewhat regular basis these analogies should be quite clear to you, but for everybody else: Scenario 1 is Facebook, Scenario 2 is Groupon, Scenario 3 is gold. I am not saying that you need to avoid investing in these ideas. I am not even saying that there necessarily will be a bubble bursting but it is inflating at a pretty rapid pace. DIAYOR (do it at your own risk)

For The Record: I am long Gold.

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