When the subject of man's folly came up, both my parents often referenced an 1852 book written by Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds. I last read it in college, but was reminded of it while reading Richard Maybury's January 2013 newsletter. He quoted Mackay: "Men, it has been well said, think in herds; it will be seen they go mad in herds, while they only recover their senses slowly, and one by one."
Mackay's book was about investment "bubbles," in which the market value of a commodity rose to irrational astronomical values because people extrapolated that increases would go on indefinitely. Huge profits led many to assume the price would continue to rise exponentially allowing certain profits when they sold at a higher price to the poor fool who didn't invest when they did. One example was investments in tulips (yes, the flower, or at least its bulb). "Tulip mania" caused a rise in tulip prices to tremendous levels and fortunes were made before the bubble broke and the price crashed. Another investment bubble was Louisiana land, long before it was part of the U.S. While it is true there is only so much land and they are not making any more of it, the price paid for investment land must have some basis in its ability to return a profit. The profit in such a bubble, however, is in selling it when the price escalates even more. In reality, this land could not be made productive for many more years, and so the bubble eventually burst. At some point, people say this cannot keep going, and they stop bidding the price up. Then the owners see the price drop as they realize there are no buyers of what they own. Once the confidence of the market in a commodity's value is broken, the price collapses, the bubble bursts.
Of course, today we also have bubbles. Now we call them "booms." In our era, they are most often caused by an attempt to beat the declining value of government currency. When money is declining in value, cash savings are a losing proposition. People realize their currency is worth less and less, so they are desperate to invest in such a way they make more than they lose to inflation. Desperate investment, however, is often foolish investment. The more people perceive their currency is of questionable value, the more they are prone to climb aboard speculative booms. By the time most people get in on the boom, however, the corresponding bust is often just around the corner. Most see the upward spiral and jump into "easy profits" near the top of the curve.
In the 1990s we saw the dot-com boom. While many innovative computer companies were exploding in value, many more were little more than ideas, with no signs of profitability. Yet the prices for dot-com stocks kept rising in classic bubble fashion. Many said it could not go on forever, and indeed it could not. The bust came, and many were left holding worthless shares of defunct companies.
Then, after the turn of the century, we saw another bubble in real estate. As long as people thought property was a guaranteed means of making money, prices rose rapidly every year. Several television reality shows showed investors, sometimes rank amateurs who overextended themselves, buying homes in order to "flip," or resell them within weeks at a large profit. Many said it could not go on forever, and it didn't. The market peaked in 2006 and the boom turned to bust and real estate prices dropped drastically. It was the bursting of the real estate bubble that led to the bank crisis of 2008.
Our government has also created a type of bubble or boom in the value of the dollar itself. When Nixon took us off the international gold standard in 1971, he propped up the value of the dollar by persuading oil producers to only trade oil in dollars. This was a brilliant act by Nixon, though not so smart perhaps by those who agreed to be tied to the dollar. These petrodollars help keep the value of the dollar artificially high. Anyone who wants oil needs our dollars, so an artificial demand is created keeping the value of the dollar high. What is worse about most of our modern bubbles is that they are, in part, created by governments. Recently, the Federal Reserve said it would create as much money as necessary to raise stock prices. Our economy is now largely based on government influx of cash to keep it going. Ponder that when you think your stocks are doing well. Markets are now a reflection on the government's artificial stimulation of the economy.
Those who are caught holding a worthless investment when the bubble burst are ruined. All modern currencies are bubbles, and holding them is risky. If your speculation can keep you ahead of the loss to inflation, you are doing well; but that will not help you when the dollar itself collapses. When I recommend gold to people, many think I am advocating it as a commodity like pork bellies. I'm not. I'm suggesting it as an alternative way of holding your assets. I tell people, if you are not investing in gold, you are investing in the dollar.
It's easy to be caught up in the herd mentality, and assume there is little risk if you are doing what many others are doing. This is true, unless, of course, the herd is racing toward the cliff. The herd mentality works for you in a boom; but it carries you along on the ride for the bust as well.