Investments & Securities

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Ten Commandments of Investing

Ten Commandments of Investing

Guiding Principles from the Greatest Investment Wizards
edition:Paperback
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Savvy Real Estate Investing

Savvy Real Estate Investing

Create a Passive Income Stream and Make Money in Your Sleep
edition:Paperback
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Picking Winners

Picking Winners

the Inside Story From Scott Fraser, Co-Founder of the Legendary Canadian Investment Firm, Jarislowsky Fraser
edition:Hardcover
tagged : finance
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Up and to the Right

Up and to the Right

The Story of John W. Dobson and Formula Growth, Second Edition
edition:Hardcover
also available: eBook Hardcover
tagged : business
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Live Happy

Live Happy

The Best Ways to Make Your House a Home
edition:Paperback
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Canadian Cannabis Stocks Simplified

Canadian Cannabis Stocks Simplified

A ‘How-To’ Guide for the Budding Investor
edition:Paperback
tagged : investing, stocks
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When the Bubble Bursts

When the Bubble Bursts

Surviving the Canadian Real Estate Crash
edition:Paperback
also available: eBook Paperback
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Excerpt

Chapter 1
Canada’s Housing Bubble Defies Gravity

The market for real estate, particularly individual homes, would seem likely to display speculative booms from time to time, since the psychological salience of the price of the places we see every day and the homes we live in must be very high, and because homes are such a popular topic of conversation.
— Robert Shiller, Irrational Exuberance, 2000

One of the earliest uses in recorded history of the word bubble in relation to financial speculation was in reference to the South Sea Bubble — the South Sea Company was a joint-stock company founded in England in 1711. It issued shares to the public in 1719 and in less than a year increased its stock market value ten-fold. A short time later, its stock price had dropped back to close to the original listing price, a crash that reduced the value of the company by 90 percent. Fortunes were made and lost. Despite the huge devaluation in the share price of the company, it continued to exist; indeed, it eventually took over responsibility for the debt of the Government of the United Kingdom.

The Bubble Company, as it was known, copied the Banque Royale, a company that was formed in France in 1716, which was also organized as a joint-stock company and used to finance government debt. Both of these companies were created for the purpose of converting government debt into shares of stock in a listed company. This idea of paying off government debt with shares sounds crazy today, but, at that time, it fired the public imagination and many ordinary people got caught up — speculators would eventually lose their life savings. These two companies and other similar copycat companies became known as the bubble companies. The concept became so popular that the U.K. parliament passed the Bubble Act in 1720 to control them.

Another, more famous, instance of financial insanity and speculative fever was a period known as the tulip bulb mania, which started in Holland in 1634–37. It seems that this mania wasn’t referred to as a bubble, perhaps because of the difficulty for the human tongue in saying “tulip bulb bubble.” Some people, wealthy and poor alike, became besotted with the idea of owning and trading tulip bulbs for financial gain. Bulbs were listed for trading like a stock on one of the earliest stock exchanges, the Amsterdam Exchange. Prices soared to the equivalent of an average person’s life savings for one rare bulb. The fad spread to England and many other countries. Even today, in Holland rare species of tulip bulbs trade at lofty prices, although nothing like the ridiculous values that were common four hundred years ago.

The principal attributes of these activities, whether called bubbles or not, were a degree of excessive speculation, inflated prices, and a subsequent crash, along with widespread public involvement and fascination.

Many writers and historians have tried and failed to make sense of the innumerable instances of inflated values for commodities, stocks, real estate, and other speculative vehicles caused by excessive greed and speculation. Economic theory doesn’t do any better in providing explanations, since bubbles don’t readily allow analysis using advanced mathematics. Modern economic theory avoids the difficulty of understanding bubbles and mania by assuming that all human participants in economic activities are rational at all times under the efficient markets hypothesis. Even Canadian-born economist John Kenneth Galbraith — who discussed many of the most extreme bubbles in A Short History of Financial Euphoria, and provided analysis that does a much better job of explaining economic cycles than do most of his peers and successors — fails to come up with a suitable definition of the bubble phenomenon. Galbraith merely states that they are recurring episodes of collective financial insanity, fuelled by greed, and that they are inevitable.

Given the difficulty of experts who have studied bubbles in detail in coming up with a coherent explanation regarding the origin of bubbles, their nature, or patterns, it’s not surprising that it’s next to impossible for the average person to detect when they are in the grips of a manic episode of excessive speculation. The only defence is to develop a healthy degree of skepticism, an attitude that comes naturally to few people.

One such person is Jeremy Grantham, the founder of the large investment firm GMO, who manages over $120 billion of investments for institutional investors such as pension plans, endowment funds, and companies. I first met him in New York City after he presented at a conference in 2003. He opened his remarks by stating, “I’ve never been wrong.” The room went completely silent as two hundred investment experts and portfolio managers mulled that over. After a very long, awkward pause, he continued, “I’ve been early,” and the room erupted into laughter.

Grantham captured in a very succinct manner the universal difficulty of talking about bubbles and the inevitability of them bursting. Any prognosticator who calls for a crash in a bubble asset invariably looks like a fool for a period of time before eventually, perhaps, being proven right. In the interim, the forecaster predicting the collapse is contradicted by higher and higher prices leading to greater and greater wealth for the bubble participants who ignore the warnings. Inevitably, the public (and clients if the advisor is in the investment business) develops disdain for the person making the unfortunate “early” prediction. As Grantham says in an April 2014 GMO quarterly letter, “the pain will be psychological and will come from looking like an old fuddy-duddy.” However, in the big picture of cycles, those who were forecasting a collapse in the U.S. housing market in 2004 and 2005 were only a year or two early. In real estate, one or two years is a short time. It takes that long sometimes to get a house ready to sell, put it on the market, and wait for the right buyer to offer the right price. Grantham was very early in 2003 with his predictions about a stock market crash, but eventually he was more than right. When the financial crisis hit in 2006, it began with housing, and the next year spread to the financial industry, eventually resulting in the collapse of Bear Stearns, and, in 2008, Lehman Brothers.

Grantham described his research into bubbles. His research showed that “all [ twenty-eight] major bubbles … eventually retreated all the way back to the original trend, the trend that had existed prior to each bubble, a very tough standard indeed.” The definition used for a bubble was any event that was two standard deviations from the mean. Standard deviation is a statistical tool that tells how unusual an event is. Bubbles of that size, according to Grantham, are expected to occur at a frequency of once every forty-four years. The U.S. housing bubble exceeded 3.5 standard deviations from the mean, an event that would be expected to happen very rarely, only once every five thousand years. The U.S. housing bubble started to take shape in 2000, reached one standard deviation about the trend line around 2001, exceeded two standard deviations during 2003, and peaked above three standard deviations in 2005, going to one standard deviation below the mean in 2008. All done in about eight years, a very compact and devastating bubble and bursting that will have repercussions for the United States and the world for decades.

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