Investment Bubble versus Long-Term Investment - Personal Statement Example

? Investment Bubble Introduction Investment bubble is now a well known phenomenon that has taken place in various es of assets such as real estate, stock market or bullion market throughout the world. When a particular class of investment performs extraordinarily well, it draws attention of variety of retail investors. Having found an opportunity, they rush and invest in that class of asset thinking a lot of heat is still remaining. This brings more money giving rise to the price of the asset. Increased price gives confidence to the investors and they flock to the market with increased vigor and enthusiasm. Virtually, a spiral sets in with more investment coming through causing more escalation in price of the said asset. Within few months price soars beyond imagination of all and the level of rationality. Even at this level, buying keeps supporting the price. Those who were not the part of this boom feel like having missed the bus and decide to plunge into it with all available resources. Soon, price reaches to a level, which cannot be justified by any of the known established investment theories even after discounting all future cash flow streams in a most optimistic scenario. Such a level of price cannot be sustained for a long period of time and discerning speculators start unloading at the peak of the heat. Price starts falling quickly and gullible retail investors who are in thousands cannot fathom that ‘bubble has burst indeed’ and hold on to their investment causing them insurmountable loss in the asset wiping their most of the capital. It will be worth exploring and to live some of the investment bubbles in a different class of assets across the world before identifying the key issues involved with an investment bubble versus a long term investment. Japanese Stock Market Bubble It will be interesting to track the movement of Nikkei 225 between the period of 1983 and 1991to understand how did the stock market burst eventually. The index which was hovering Source:http://www.chartsrus.com/chart.php?image=http://www.sharelynx.com/chartstemp/free/chartind1CRU.php?ticker=^N225 around 8,300 in 1983 peaked to more than 38,000 in December 1989. The boom period continued for almost 6 years giving a stupendous rise to the stock price. For many, it was a great period of investment giving them return of 500% or more. However, the bubble burst after that and index came down crashing to nearly half at 19,000 within a year. It plunged further down to 14,000 by third quarter of 1993. The most tragic part is that the exactly after 20 years Nikkei touched the same level of 8,300 that is where it started off in 1983. It was a complete reversal and complete washout of investment. (Japan Nikkei 225 2011) Investment Bubble versus Long Term Investment Above incident raises several issues worth contemplating. A common understanding among investors is that the investment always rises with time and with the expansion of economy, but here a totally different phenomenon has surfaced. Anyone who invested in Japanese stock market in 1983 and stayed with the investment until 2003 virtually had no return on his or her investment though it may be termed as a long term investment without resorting to any speculative activity. Investor is back to square one. This certainly defies the theory that a long term investment always pays. Japan has certainly progressed between 1983 and 2003 that is evident from the GDP figures. In 1983, Japan’s GDP was $10,987.22 (Japan GDP - per Capita 2011) in terms of purchasing power parity point of view which grew to $33,884.84 in the same terms. It is true that the bubble has burst but how to justify the same valuation even after 20 years. This indicates that the rise and fall of the investment is not always linked to the time and economic expansion in general. It is a quantum of the money chasing targeted asset plays a pivotal role in the appreciation of an asset. Bubble in Precious Metal In another class of asset namely Gold, the situation is again not much different. During economic or currency crisis situations many investors prefer a long term investment in white and yellow metal thinking they will get reasonably safe return and their capital will not get wiped out. Below is the graph showing price movement of gold between 1968 and 2000 Source: http://www.kitco.com/charts/historicalgold.html The prices are in US dollar per ounce. In 1970, the average price of gold was $35.94 per ounce which in 1980 went up to $612.56 per ounce. A fabulous return of almost 1600% in ten years indeed! Anybody would conclude that gold is a finest class of asset for investment and would plunge into it for investment at every decline. Surprisingly, gold price touched to almost $330 per ounce in March 1982 and an investor who had made an investment at its peak price of $600 must have halved his or her investment in next two years only. The story of gold investment between 1970 and 1982 exemplifies a rewarding long term investment in first 10 years and then bursting of the bubble so that investment value goes half. Further, if the prices of gold between the years 1982 and 1998 are compared then it is evident that an investment made in 1982 by an investor with a view of long term investment and holding it until the year 1999 would have reduced its capital as price in 1999 touched at its lowest at $270 per ounce. Quite a long period of investment spreading up to 17 years would not fetch any return in this yellow metal. Does it mean that investment in gold was a bubble that burst in the year 1980? Then what about a phenomenal return that investors received between 1970 and 1980 in gold? Each investor will have their own perception to call gold investment as bubble or an asset worthy of investment for a long term depending upon where they entered and where they exited. The story of gold does not end here. On chasing its price movement from 1999 until 2011, it is again a remarkable class of asset giving a fabulous return of 500% and more as current price of gold is ruling at around $1820 per ounce. Thus, the gold investment bubble and a reward to the long term investors continue in a cyclical order. It is a matter of timing in entry and exit that decides whether one is trapped in bubble bursting or one is rewarded enormously. US Housing Bubble The recent housing bubble in US is another case in the series which is worth considering for discussion. The price movement between 1970 and 1990 from the graph that follows indicates that the nominal price rise was almost 400%. Source: http://www.jparsons.net/housingbubble By any standard one may be tempted to state that it is a good long term investment during that period. But the crux of the thing is that it is not when the price is adjusted to the inflation as inflation adjusted price movement (shown in red line) during the same period does not show any appreciable return. The real appreciation starts from the year 1998 onwards which peaked in the year 2006 doubling the value in 8years. In a low interest regime during the period, this could be termed as a good long term return. The healthy appreciation in the real estate was eventually followed by a bubble burst destroying all the appreciation gained by any gullible investor through a long term investment strategy. Currently, price is down by more than 30 percent from the top and still the downward trend continues and no sign of any respite. Speculative Buying Fuelled by Easy Money from Lenders U.S real estate phenomenon of boom followed by burst is largely attributed to the low interest rate that prevailed beyond 2001. The Fed repeatedly reduced interest rates which made it easier for the people to borrow. Virtually, the cost of investment was nothing. Moreover, US tax laws encouraged people to borrow for they can deduct the interest charge from their income, which they need to pay for their mortgaged asset. The demand was further fueled by underwriting of mortgages done by big institutions such as Fannie Mae and Freddie Mac. With lowest interest rates in 2001 and 2002 people heavily borrowed and invested in housing. For many, it was an investment in the second housing unit in their life. It was obvious that soaring demand fuelled this boom as too much money was chasing limited supply. As happens in every boom, investing in real estate in U.S turned into an euphoria among all classes of people so much so that even low-income home buyer was also able to buy a dwelling unit through mortgage route. Adjustable-rate mortgages were helping them as in initial years buyers had to pay less with subsequent rise in installment payments during later years. It was purely a speculative buying fuelled by overly supply of easy money by lenders at very low rates. Lenders did not take in reckoning the long term paying capacity of borrowers. To contain the inflation, the Fed was raising the interest rates continually, which was also raising the repayment installment of the borrowers causing many borrowers to default on the payment. Subsequent foreclosures led to the glut in the housing supply collapsing the whole real estate market and bursting the bubble. Long Term Investment The markets of prime asset such as stocks, gold, real estate are always volatile and tend to fluctuate widely over time. Each boom cycle regardless of its length and period, will invariably succumb to its pressure though many may call it as investment bubble. No long term investment is sustainable for an indefinite period as said by Shiller (2005). The proponents of a ‘long-term-investment-strategy’ tend to hold the asset permanently unless they need the money for some cause. The episodes of Nikkei, gold and real estate clearly indicate that it is never a prudent decision to hold the asset permanently as it may give a big life time jolt to such investors from which it may be difficult to recover. In fact, history is replete with the incidents that the long term appreciation of an asset is always followed by a bust cycle and most of them indicate that there is nothing like a permanent and secured long term appreciation of an asset. In fact each bout of appreciation in an asset is followed by equally powerful burst. Shiller (2005) has called it an irrational exuberance, which is same as animal spirits, a term given by Keynes. It is simply not due to speculative activity but the characteristic of human nature that leads to this state of affairs. Bubble Busting and Investment Dilemma The phenomenon of investment appreciation and investment bubble is a phenomenon of expansion and contraction in a given asset class. The reasons are many and varied. It could be economic deregulation by the government, changed perception by a large class of investors or economic crisis forcing people to invest in certain class of assets. Also, it is not possible for a common investor to fathom the real cause behind the market movements and business cycles. It is also a fact that many investors have apprehension in their mind regarding investment bubble and they do not want to invest for the fear of losing the capital. Recommendations and Conclusion Having gone through several real-life episodes of a long term boom and bust cycle, some cardinal principles can be formulated on the aspects of investment. There is nothing like a permanent long term investment strategy. In fact, it could be suicidal for an investor to hold the asset after seeing a huge run up. The investor must exit at an appropriate time once they have a decent return in the asset. Those who do not may get trapped in the bubble eventually with nil or negative return. It should be kept in mind however, that it is not possible to define the long term investment cycles and its length of period and that is why it is equally difficult to predict when such cycles will get derailed. In a given scenario, a keen study of chart as propounded by Jiler (2003) informing the movement of an asset for a reasonable period, short term and long term both, could help investors a lot. Most of the successful investors throughout the world take a clue from the price-chart of the asset. The chart of an asset for a long period states about so many aspects. Crossing a price beyond a critical point is an indication of smart money entering the asset. Usually, the phenomenon of boom or bust never ends in a few days but lasts for several months or years. A keen observation with patience will have indication that process of boom has set in as price crosses the top most level observed in the last few years. Market always moves in zigzag way and with each movement a new top is formed. Investor may enter for an investment after seeing large price movement upwards with large volume activity and hold the asset until major drop from the top is observed. Initially, market moves up in small tranches and gathers steam only after a few months. (Jiler 2003) Similarly, exit is equally important to safeguard the investment. Usually, any sudden and abnormal rise should be taken as first signal that market is likely to get tapered off soon. Even investor need not worry for exit at this time. The graph of Nikkei 225 as seen above indicates that a steep price rise was noticed in the last phase that began in January 1989 and culminated in December 1989; however that becomes a purely judgmental. The first major fall from the top is an indication that investor must exit from an investment. With the next available opportunity, investor should set their exit point and come out from the investment. Investor should never reenter in that asset class again as the down ward cycle started now may take several months or years to get complete. (Jiler 2003) References 1. Japan Nikkei 225 (2011), online October 21 2011 http://www.chartsrus.com/chart.php?image=http://www.sharelynx.com/chartstemp/free/chartind1CRU.php?ticker=^N225 2. Japan GDP - per Capita PPP (2011), online October 21 2011 http://www.indexmundi.com/japan/gdp_per_capita_(ppp).html 3. Gold Monthly Averages (1968-1999), online October 21 2011 http://www.kitco.com/charts/historicalgold.html 4. United states House Prices (2010), online October 21 2011 http://www.jparsons.net/housingbubble 5. Jiler, W. (2003), How Charts Can Help you in the Stock Market, McGraw-Hill 6. Shiller, R.(2005), Irrational Exuberance, Second Edition, Princeton University Press, Princeton (p 233) Read More