Bubbles have become an almost routine part of the financial world; “predictable surprises” as they were called by Bazerman and Watkins in a 2004 book of the same name.
James Montier, the author of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," argued in chapter 11 that we should take predictable surprises seriously, despite the seemingly oxymoronic character of the term.
Predictable surprises
But let’s start with a definition from Montier’s employer:
“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 ypothesis, 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.”
Montier also wanted to distinguish bubbles from “black swans,” the name Nassim Taleb gave to highly improbable events with massive impacts. Montier made the distinction because black swan events are unpredictable surprises, while bubbles are predictable surprises. If the surprise was unpredictable, we can absolve ourselves by saying there was no possible way we could know this shock was coming. If the surprise was predictable, however, then we should have at least known they were coming.
Getting more detailed, he provided these three criteria for a bubble:
- Some people know there is a problem.
- The problem gets worse as time passes.
- The problem eventually explodes into a crisis, surprising most people.
Timing
While it may be true that predictable surprises (including bubbles) can be foreseen, there is always uncertainty about their timing. So, if they are predictable, why can’t we see them coming? Montier put forward these five “psychological hurdles”:
- Overoptimism: Which has been addressed in earlier chapters and means we don’t expect these events to affect us.
- Illusion of control: Montier calls this “the belief that we can influence the outcome of uncontrollable events.”
- Self-serving bias: Meaning we knowingly or unknowingly interpret information in ways that support our own self-interest. He added this Warren Buffett (Trades, Portfolio) quote, “Never ask a barber if you need a haircut.”
- Myopia: Too much emphasis on the short term. This time, he turned to Saint Augustine for a quote, “Lord, make me chaste, but not yet.”
- Inattentional blindness: Montier defines this as not seeing what we were not looking for. It also suggests getting caught up in the noise and missing the signal.
Getting ahead of the bubble
Montier started this remedial section with a quote from Herb Stein: “If something can’t go on forever, it won’t.” Put another way, if stock prices seem to good to be true, they likely are.
With the stage set, he provided John Stuart Mill’s five-step model of booms and busts, based on a paper published in 1867:
- Displacement: A shock from outside sets up new profit opportunities in some sectors while closing them in others. It is the birth of a boom and attracts financial and physical resources.
- Credit creation: This is the “nurturing” stage of a bubble, since bubbles require credit as well as capital. Montier quoted Mill as saying, “The rate of interest [is] almost uniformly low. . . . Credit . . . continues to grow more robust, enterprise to increase and profits to enlarge.”
- Euphoria: At this stage, everyone is becoming aware of the exceptional growth and buying. Almost everyone believes prices will only go up. Montier cited Sir John Templeton, “This time is different.” I will add my favorite: “You can’t lose.”
- Critical stage—Financial distress: Insiders begin extracting themselves and, inevitably, financial distress follows. Two forces exacerbate the problem: excess leverage and fraud.
- Final stage—Revulsion: The bubble bursts, leaving its investors scarred by their experience and vowing they will never invest in the market again. For value investors, this is the time to go shopping, with many bargains becoming available.
An amateur’s edge
Montier argued that amateurs have a big edge over professionals in dealing with bubbles because they do not have to adhere to an arbitrary benchmark.
He also said professional investors could help moderate bubbles by arbitraging against them. Unfortunately, most professionals do not:
“...because of self-serving bias and myopia. They are benchmarked against an index and fear underperforming that index above all else (aka career risk); thus they don’t have the appetite to stand against bubbles.”
Because amateurs need not be concerned about career or business risks, they have a significant advantage over professionals.
Montier summed up this way:
“Investors should remember bubbles are a by-product of human behavior, and human behavior is all too predictable. The details of each bubble are subtly different, but the general patterns remain eerily similar. As such, bubbles and their bursts are clearly not black swans. Of course, the timing of the eventual bursting of the bubble remains as uncertain as ever, but the patterns of the events themselves are all too predictable.”
Conclusion
Montier begins chapter 11 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy" by calling bubbles "predictable surprises." Unlike black swan events that truly are unpredictable, bubbles can be identified well before they burst.
He gave five reasons why many of us get caught up in bubbles, and awareness of these blindspots may help us avoid entanglement. Even more help comes in the form of a five-step model of the life of a bubble, courtesy of Mill.
Montier concludes by letting amateurs know they have an edge over professional investors in dealing with bubbles. They are not locked into the career and benchmarking criteria that handcuff the pros.
About Montier
The author is a member of the asset allocation team at GMO, the firm founded by Jeremy Grantham (Trades, Portfolio) in 1977. According to his Amazon profile, he was previously co-head of global strategy at Société Générale (XPAR:GLE, Financial). The author of three books, he is also a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. The book we are discussing was published in 2010.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
