Saturday, April 20, 2013

Behavioral Finance Explains Bubbles

A great depiction and explanation of economic bubbles. Aivars Lode

Editor’s note: Adam Nash is the chief operating officer of Wealthfront, a SEC-registered, software-based financial advisor located in Palo Alto. He was formerly executive-in-residence with Greylock Partners and VP of product management at LinkedIn. Follow him on his blog and on Twitter at@AdamNash.
“Bubbles are beautiful, fun and fascinating, but do you know what they are and how they work? Here’s a look at the science behind bubbles.” – Chemistry, “Bubble Science”
“Double, double toil and trouble
Fire burn, and cauldron bubble.” – Macbeth, Act 4, Scene 1
Given the incredible volatility we’ve seen lately in the Bitcoin and gold markets, there has been a resurgence in discussion about bubbles. This topic is always top of mind in Silicon Valley, especially given that the two favorite local topics of conversation are technology companies and housing.
Defining a market bubble is actually a bit trickier than it might first appear. After all, what differentiates the inevitable booms and busts involved in almost any business and industry from a “bubble”?
The most common definition of a speculative or market bubble is when a broad-based, surging euphoria or wave of optimism carries asset prices well beyond supportable value. The canonical bubble was the tulip mania of the 1630s, but it extends across history and countries all the way up to the Internet bubble of the late 1990s and the housing bubbles in the past decade.
Not surprisingly, there are a number of great frameworks for thinking about this problem.
In 2011, Steve Blank and Ben Horowitz debated in The Economist whether or not technology was in a new bubble. In those posts, Steve cited the research of Jean-Paul Rodrigue denoting four phases of a bubble: stealth, awareness, mania and blow-off.
bubble chart
(Source: Wikipedia)
In 2000, Edward Chancellor published an excellent history and analysis of market bubbles over four centuries and a wide variety of countries called “Devil Take the Hindmost: A History of Financial Speculation.” In his book, he finds at least two consistent ingredients.
Uncertainty. In almost every bubble, there seems to be some form of innovation or insight that forces people to rapidly debate the creation of new economic value. (Yes, even tulip bulbs were once an innovation, and the product was incredibly unpredictable.) This uncertainty is typically compounded by some form of lottery effect, exacerbating early pay-offs for the first actors. Think back to stories about buying a condo in Las Vegas and flipping it in months for amazing gains. This creates the inevitable upside/downside imbalance that Henry Blodget recently framed as: “If you lose your bet, you lose 100%. If you win your bet, you make 1000%.” Inevitably, this innovation always leads to a shockingly large assessment of how much value could be created by this market.
Leverage/Liquidity. In every bubble, there is some form of financial innovation that broadly increases both leverage and liquidity. This is critical, because the expansion of leverage not only provides massive liquidity to fund the expansion of the bubble, but the leverage also sets up the covenants that inevitably unwind when the bubble turns aggressively to the downside. In some ways, it’s also inevitable. When a large number of people believe they’ve found a sure thing, logic dictates they should borrow cheap money to maximize their returns. In fact, the belief it may be a bubble can make them even greedier to lever up their investment so they can “cash out” the most before the inevitable break.
Bubbles clearly have an emotional component, and to paraphrase Dan Ariely, humans may be irrational, but they are predictably irrational.
There are five obvious attributes of components of bubble psychology that play into market manias:
  1. Anchoring. We hear a number, and when asked a value-based question, even unrelated to the number, they gravitate to the value that was suggested. We hear gold at $1,500, and immediately in the aggregate we start thinking that $1,000 is cheap and $2,000 might be expensive.
  2. Hindsight Bias. We overestimate our ability to predict the future based on the recent past. We tend to over-emphasize recent performance in our thinking. We see a short-term trend in Bitcoin, and we extend that forward in the future with higher confidence than the data would mathematically support.
  3. Confirmation Bias. We selectively seek information that supports existing theories, and we ignore/dispute information that disproves those theories. (This also tends to explain most political issue blogs and comment threads.)
  4. Herd Behavior. We are biologically wired to mimic the actions of the larger group. While this behavior allows us to quickly absorb and react based on the intelligence of others around us, it also can lead to self-reinforcing cycles of aggregate behavior.
  5. Overconfidence. We tend to over-estimate our intelligence and capabilities relative to others. Seventy-four percent of professional fund managers in the 2006 study “Behaving Badly”believed they had delivered above-average job performance.
The greater fool theory posits that rational people will buy into valuations that they don’t necessarily believe, as long as they believe there is someone else more foolish who will buy it for an even higher value. The human tendencies described above lead to a fairly predictable outcome: After an innovation is introduced and a market is formed, people believe both that they are among the few who have spotted the trend early, and that they will be smart enough to pull out at the right time.
Ironically, the combination of these traits predictably leads to these four words: “It’s different this time.”
After two massive bubbles in the U.S. in less than a decade, many people question spotting bubbles ahead of time is so difficult. In every bubble, a number of people do correctly identify the bubble. As in the story of the boy who cried wolf, however, the truth is apt to be disbelieved. The problem is that in every market, there are always people claiming that prices are too high. That’s what makes a market. As a result, the cry of “bubble” is far more often proven wrong than right.
Every potential bubble, however, provides an incredibly valuable frame for deepening and debating the role of human psychology in financial markets. Honestly and thoughtfully examining your own behavior through a bubble, and comparing it to the insights provided by behavioral finance, can be one of the most valuable tools an investor has to learning about themselves.

Thursday, April 18, 2013


A little too much ranting in the following dialogue, however the comparison to why australia got rid of the penny and other small coins makes this interesting reading. Aivars Lode

By Dr. Steve Sjuggerud
Thursday, April 18, 2013 
How dumb are we as Americans?

More specifically, how irresponsible and stupid is the U.S. government when it comes to our money? And how foolish are we to put up with this?

"Wow, what's got Steve so riled up today?" you might be wondering.

I just got a reminder that you and I HAVE to diversify some of our wealth outside of the U.S. dollar. The incompetence in government is just too massive.

Let me explain…

I was just reading the Annual Report from the U.S. Mint. These are the guys who produce our coins.

In short, you take a piece of paper, worth one cent… You print the words "Twenty Dollars" on it (at a cost of a couple pennies per bill)… And you make a profit of… well… about $20 (give or take a couple pennies). Right?

Actually, in a few instances… our government manages to LOSE money from MAKING money.

Wow. Losing money from making money… That's got to be hard to do, right?

In 2012, it cost the U.S. Mint two cents to create a penny. I am not rounding up. It cost two cents. That is actually down from 2011, when it cost 2.4 cents to make a penny.

It's not just the penny… Last year, it cost the Mint over 10 cents to create each nickel in 2012.

When you add it up, our brilliant government lost nine figures last year alone (that's a number in the hundreds of millions) simply on minting pennies and nickels last year.

And our government lost more than $100 million on MAKING MONEY – something that should be a guaranteed profit!

Think about it this way…

The federal government takes your money in taxes – one-third of your income. And then it uses that money to mint pennies and nickels – at a major loss… at a cost of twice the face value of the coins!

Your government has an incredible power – to mint money out of thin air. And it is so incompetent, it manages to lose twice the face value of those coins on every one that is made.

Even crazier, this has gone on for years… and your government hasn't done anything about it. For proof, check out this actual quote from the U.S. Mint's 2012 Annual Report (emphasis mine):
The costs to manufacture and distribute both the one-cent and five-cent coins exceeded their face value again, just as they have for each of the last six years. This negative seigniorage concerns us, and we continue to explore ways to address it.

Your government has lost money from printing pennies and nickels each year for the last six years… And it is still "exploring ways to address it."

Your government commissioned a two-year study from an outside company to figure out what to do, which just concluded in December 2012. The result was… nothing! It apparently needed more time to reach a conclusion.

How much time do you need? I can solve this problem in 20 seconds…

You have two choices:
•  Stop minting the coins you're losing money on (for example, get rid of the penny).
•  Start minting money using a material (like steel for a nickel) that's worth less than its cost of production.

Done! How much should I get paid for that absolutely correct advice? Didn't even take me one year!

This is not rocket science. Australia figured this out in 1991 and got rid of its pennies. It's been done before. Our government is just failing here.

I realize that a loss of hundreds of millions of dollars is nothing for a government that spends trillions of dollars more than it takes in each year. But it is an entirely fixable problem… that has gone on for six straight years. To me, this says something about our government.

And you know what? You and I might just be more foolish than our government…

For some reason, most Americans hold most of their money in American dollars – money "backed" by a government so inept, it manages to lose money making money (in pennies and nickels).

But money flows to where it's treated best… that is one of the surest things in finance. And right now, our government spends two pennies to mint one penny… and spends trillions of dollars each year beyond its means.

That's why, in the upcoming issue of my True Wealth newsletter (out this week), I suggest readers get some of their cash OUTSIDE of the U.S. dollar and into a safer place.

Out of fairness to my paying True Wealth subscribers, I can't share my specific recommendation with you. But I urge you to recognize the lunacy of the situation here… And diversify at least some of your money outside of the U.S. dollar.

Starting right now (for reasons I explain in my upcoming True Wealth issue), you will be glad you did…

Good investing,


Tuesday, April 16, 2013

Hack attacks hit Bitcoin exchange rates

Even virtual currencies have their issues. Aivars Lode

Online services and exchanges dealing in Bitcoins have been hit by hack attacks that led to a drop in the value of the virtual currency.
Trading on the MTGox exchange, which handles most trades in Bitcoins, was sluggish yesterday as the site fought off an attack.
The attack helped to force a swift fall in the price of Bitcoins.
In addition, the Instawallet website - where people store Bitcoins - is offline indefinitely after an attack.
Website bombarded
The value of Bitcoins surged to a new high this week with each one worth about $142 (£94). Barely a week ago, each virtual coin was worth only $90.
But Bitcoins dropped sharply in value as the MTGox exchange came under a sustained attack by hackers. The vast majority of trade in Bitcoins takes place via the site.
In a tweet on its Twitter feed, MTGox said it was fighting off adistributed denial-of-service (DDoS) attack, which involves a site being bombarded with huge amounts of data. The attack was one of several against the site this week,
The attacks, coupled with a spike in trading volumes, combined to cause delays in trades being confirmed and led the value of Bitcoins to drop sharply to about $120.
MTGox said in an interview with ComputerWorld. Attackers are thought to be working to a cycle in which they sell Bitcoins when values are high, then mount an attack that forces prices to crash, buy up the cheaper coins and then let the value climb again.
MTGox said it did not know when or if the attacks would cease but said Bitcoin owners should not panic and sell off as values fluctuated. A spokesman for the exchange added that it was in the middle of rebuilding its trading technology but the new system, which would do a better job of handling the high volume of trades, would not be ready until the end of this year.
In a separate development, Instawallet has shut down "indefinitely" after hackers "fraudulently accessed" its core database. In a statement posted on the Instawallet site it said it planned to open a claim process shortly so people could reclaim their Bitcoin balance.