When a particular investment (or class of investments) performs particularly well this tends to draw the attention of investors. This in turn leads to more money being put into the investment which causes further price rises which makes still investors more confident.

This leads to an upward spiral that takes prices far above the levels which can be justified by any rational assessment of the real value of the future cash flows an investment may generate. This is an investment bubble.

Even investors who are aware that there is a bubble, and that prices are too high to justify on fundamentals, frequently buy into bubbles. One reason is the greater fool theory, which, unfortunately, is often correct during bubbles.

Another reason is that investors may not wish to miss opportunities that others are taking. For private investors this is likely to be merely the fear of being left out. In the case of professionals, such as fund managers, those who stay out of a bubble will be seen to be under-performing. During the dot com bubble some fund managers who stayed out of overpriced internet stocks lost their jobs as a result of the poor performance (relative to the market) of their funds.

During bubbles investors (and analysts) tend to try to rationalise high valuations. For example, during the dot com bubble some analysts were valuing internet companies using market cap per user as a valuation ratio. They compared internet companies against each other without taking into consideration the ability of any of them to convert popularity with users into cash flows.

Part of the problem is the focus sell-side analysts have on narrow sectors, and therefore on sector relative valuations. This is much less serious than the more fundamental problem of the power of herd instinct and the fear of being left out - and the fear of publicly making a controversial wrong call.

As a result of this the explanation of bubbles is largely a matter of behavioural finance rather than valuation theory.

Bubbles inevitable ultimately lead to a price crash. These often mirror the characteristics of a bubble and can be a valuable buying opportunity.

Copyright Graeme Pietersz © 2005-2019