Why advisers often struggle with bubbles

“If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring. ”
– George Soros1

From time to time, we come across finance phenomena that ignite the senses – that captures society’s imagination and interest, in a way that frankly, it probably shouldn’t.

The latest phenomena I would put into this category are cryptocurrencies – and bitcoin specifically. Although I do not have the expertise or requisite understanding of cryptocurrencies to make a fully informed assessment of them, my background in finance and economics forces me to challenge their merit as a form of valuable exchange.

Yet people from all walks of life are happy to promote cryptocurrencies as the greatest new world-changing invention. Media coverage of newly-minted bitcoin millionaires is widespread and this fuels people’s interest. This is not the first time we have experienced a ‘bubble of exuberance’, so what lessons can be learned from experience:

Saying ‘I don’t know’ to clients can be difficult

Many advisers have been asked by their clients whether they should invest in bitcoin, a fair question given the amount of recent media coverage devoted to cryptocurrencies. The problem is that clients may expect advisers to be deeply knowledgeable on this latest financial innovation, when in reality very few will know a great deal about it. Nor should they. An adviser’s role is not to pick the next ‘hot investment’, rather it is to guide clients to make good decisions by preparing an achievable financial plan that will help them reach their goals.

Some good will probably emerge

Sadly, for the vast majority of bitcoin speculators, who joined the party just as it was about finished, this bubble will likely end with a financially painful pop. The main reason for this is that bitcoin is not being extensively used as a medium of exchange and has no intrinsic value other than its inbuilt scarcity. The real value of bitcoin and other cryptocurrencies are the technical and intellectual advances made by the cryptocurrency ecosystem. These will likely become the future foundations for new and productive companies.

FOMO

The fear of missing out on windfall gains is what drives bubbles. People like to think they are clever enough to find short cuts to wealth, but there aren’t any. Hard work, continual learning, patience and of course good financial advice are the most important components. When a bubble inflates, people who want to be involved rationalise what is happening and create reasons to justify why such high prices are being paid for whatever it is.

Bubbles are very exciting

This is not the first time we have experienced speculative bubbles, nor will it be the last. If we look back in time we can find many examples that demonstrate how people abandon rationality in times of an investment bubble.

Tulip mania gripped the Netherlands in the 1630s when the prices of rare varieties of tulip bulbs soared. In 1637, a single tulip bulb of a favoured variety cost up to 4200 Dutch guilders when a ‘fat swine’ only cost 30 guilders and a skilled labourer earned 150-350 guilders per year. Tulip bulbs were scarce, luxury items and speculators used this fact to rationalise high prices. Near the end of the bubble ‘Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney sweeps and old clothes women, dabbled in tulips’.2 This classic herd behaviour is apparent in contemporary bubbles and demonstrates the persistence of irrational human behaviour in relation to investment.

What is the role of the adviser in bubble times?

The study of behavioural finance suggests there are many primary emotional and behavioural biases that affect peoples’ ability to make or assess the validity of their investing decisions. Those most relevant to the cryptocurrency bubble are:

  • Anchoring – relying too heavily on the first piece of information received. For example, a bitcoin was worth 4/5th of a US cent in 2010.
  • Confirmation bias – interpreting new evidence as confirmation of existing beliefs. When it comes to investing, this means seeking out information that supports your existing belief and actively ignoring any evidence that is contrary.
  • Herd behaviour – when individuals tend to follow the behaviour of the majority.
  • Overconfidence –  a person’s confidence in their judgement or ability is higher than it objectively should be.

The voice of reason

A recent industry straw poll showed that only 1.9 per cent of advisers were ‘likely’ or ‘very likely’ to recommend cryptocurrency investments to their clients. This is good news and demonstrates that the majority of advisers are fulfilling their role of being the voice of reason.

I’m pleased to say that most of the advisers I meet and engage with play a critical role in their clients’ lives. They help them navigate the various psychological pitfalls they continually face, the latest hot investments or financial phenomena, so they can make sound decisions, avoid costly mistakes and reach their financial goals.

If you want to learn more about cryptocurrencies and the differences in their underlying technology, read our Advice Research report.

The headlong fools plunge into South Sea Water.
But the sly long-heads wade with caution after.
The first are drowning but the wise last.
Venture no deeper than the knees or waist.

This ‘bubble card’, printed in 1720, is commenting on the recently popped South Sea bubble. The sentiments expressed on the card apply well to most bubbles.

The South Sea bubble saw shares in the UK South Sea Company rise ten-fold in 1720 before collapsing. The bubble was driven partly by speculation over how lucrative its trading opportunities would be in South America. The company was granted a monopoly on trade with South America by the government but this was almost worthless as Spain controlled South America.

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1 As quoted in The Winning Investment Habits of Warren Buffett & George Soros, 2006, by Mark Tier.
2 Quote from: Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay, 1841.
3 Scanned from reprint of 1841/1852 editions of "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay.