There is a difference between investing and speculating.
Investors buy assets based on the income producing ability of that asset.
Speculators buy assets assuming someone else will buy it from them at a higher price. Nothing wrong with that, except when the assumption of a future price increase is being fuelled by a fear of missing out because of a recent price increase rather than sound economic fundamentals.
This fear of missing out increases demand, demand then exceeds supply which fuels further price increases. Price increases because of self-perpetuating hysteria and not because of an increase in real value of the underlying asset.
The hysteria surrounding cryptocurrency such as bitcoin is a recent example of this but it’s not a new phenomenon.
Following are some examples of an age-old problem in investment markets, humans behaving irrationally.
1635 tulip mania – Late in the 16th century, middle-class Dutch society came to applaud the beauty of the flower from the then-rare tulip root. By 1635, two quality tulip bulbs could be exchanged for a quality home.
Labourers, seamen and chimney sweeps joined the frenzy and overseas capital was directed at the market.
The bubble burst when buyers defaulted on purchase agreements and people lost interest in the flower. By November 1636, tulip market confidence had been shattered and panic spread across Holland.
Neither the courts nor the government could stop widespread bankruptcies.
1720: spices & slaves – The South Sea Company raised £10 million from British investors in the early 18th century by promising to deliver huge returns from the trade of slaves, spices and materials from South America.
Fraudulent claims by the company saw its share price rocket from around £100 to £1,000 at a time when an English family could live comfortably on £200 each year.
Other companies with dubious prospects raised money for more than a decade. But South Sea’s Company share price fell back to £135 by September 1720. Bankruptcies reached an all-time high. A great intellect of the time, Sir Isaac Newton, lost £20,000.
1969: The Poseidon boom – In 1969, a small miner called Poseidon stumbled across a vast reserve of nickel in Western Australia. The discovery pushed the company’s stock price from $1 to a February 1970 peak of $280.
The Times newspaper in London described Poseidon as the “share of the year if not all time” and other miners claimed equally impressive discoveries.
But by December 1970, Poseidon’s share price plunged back to $39 after investors placed a realistic value on the reserve. The company went into receivership in 1976.
2000: technology – The recognition that widespread use of the Internet had economic ramifications similar to the industrial revolution spawned a frenzy that turned the Nasdaq stock exchange into a household name.
Investors drove up the share prices of companies with few prospects of profit. The Nasdaq Composite index soared to new heights but a year later had fallen by 64 per cent.
2016 Bitcoin – The promise of Bitcoin was to leverage emerging (and still exciting) blockchain technology and provide lightning fast, near-free transactions without banks, central authorities or boundaries.
The price of a Bitcoin rose from (US$) $600 late 2016 to $20,000 during Dec 2017. During that time you couldn’t avoid hearing the opinion of an overnight crypto expert who was going to retire by age 30 by investing in Bitcoins.
2 months later the price had crashed 65% to around $7000.
The common denominator in all these boom and bust stories is that the price rise was fuelled by market hysteria – people speculating on future prices with no basis to do so other than being infected by market hysteria and then making irrational decisions.
Or in the words of old-time gold miners – fools gold.