We Study Billionaires - The Investor’s Podcast Network - TIP673: A Short History Of Financial Euphoria w/ Kyle Grieve

Starting point is 00:00:00 You're listening to TIP. Building long-term wealth relies on the ability to compound wealth for decades to come. It doesn't really matter if you're trying to track the index or outperform it. If you want to generate wealth rather than destroy it, you must reach the finish line while also maintaining capital along the way. If we use inversion to look at one of the most surefire ways to prevent ourselves from crossing the finish line, I think avoiding bubbles will be near the top. Now, this is why I've always been fascinated with John Kenneth Galbraith's excellent book, A Short History of Financial Euphoria.

Starting point is 00:00:35 The book just focuses on a few very, very simple objectives. Number one, it tells you what a euphoric episode looks like in quite a bit of detail. Number two, it goes over several euphoric episodes in history using John Kenneth Galbrae's own framework. And number three, it just highlights many of the biases that are embedded in our own psychology that basically guarantee the continuation of euphoric episodes into the future. Now, while I was reviewing my takeaways from the book, the concept that I just couldn't stop thinking about was risk. Mainly, risk is always present.

Starting point is 00:01:09 And the market just fools us all into thinking that risk is absent during these times of peak euphoria. Now, this feature of open markets shows me that we must intentionally think about risk at the exact time when we don't actually want to spend any time thinking about it. Putting myself in the investors' shoes during events like Tulipomania, the South Sea Company bubble, or the Bank Royale, I can't help but think about the difficulty many market participants had in not being invested in the bubbles as they started forming. The FOMO involved back then is the exact same type of FOMO that we get in today's events, such as GameStop. Sure, some investors in GameStop did it out of their desire to stick it to Wall Street. But I think that was probably

Starting point is 00:01:51 the minority. I would say that many investors in GameStop bought the stock simply because they thought the stock price will go up and that they didn't want to miss out on any of that action. This is the same type of behavior that has existed now for over three centuries. And I bet you will continue to see it exist as long as the stock market functions. But as the book outlines, participating in these bubbles often leads to immense amounts of pain, both monetarily speaking and psychologically speaking. So any investor owes it to themselves to understand how bubbles work, why they form, and the bias behind participants. This is one of the best ways to help you get to the finish line, even if you won't cross that finish line for multiple decades into the future. So if you're the type of investor who has been burned by bubble-like assets before or just want to be best prepared for the euphoric episodes in the future, you'll get a lot out of this episode.

Starting point is 00:02:43 Now, let's get right into this week's episode. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Kyle Greve. Welcome to the Investors Podcast.

Starting point is 00:03:19 I'm your host, Kyle Greve, and today I'll be going over one of the classic books on Market Booms, which is John Kenneth Gowell. Galbraith's A Short History of Financial Euphoria. Now, let's start this discussion on this very brief book by discussing the blueprint of what Galbraith calls a speculative episode. So here's the order of events of these speculative episodes. First, something new and innovative captivates the public. Oddly enough, the new development is often a variation of some sort of older design.

Starting point is 00:03:47 In this book, Galbraith covers events such as Tulipomania, John Law, and the Bank Royale, and the South Sea Company, and many, many other. others. Now, while the assets don't seem similar at a glance, they all shared that they really captivated their respective nations for a time. Second, individuals who partake in these euphoric episodes develop a sort of inflated sense of their own intelligence and the intelligence of others. Not only does this inflated sense of intelligence focus on the individuals partaking in the bubble, it also focuses on those that we're taking advice from. In a classic example of the authority misinfluenced tendency, we tend to weigh the opinions of people who have money when it comes

Starting point is 00:04:31 to financial matters. But as John Kenneth Galbraith points out, many of these people are charlatans, for lack of a better word, who don't necessarily need to be listened to despite their very obvious monetary success. This is why critical thinking is so important and why we must not attribute luck as skill. Third, the assets are often purchased with very heavy dosages of leverage. This allows individuals and or institutions to purchase even more assets with very little money up front. When multiple parties end up doing this, it can drive the price of an asset up very quickly as more and more money plows into that asset. But this also causes massive amounts of risk. We'll go over some great examples of this throughout history, including some modern

Starting point is 00:05:15 examples that occurred after the book was published. Fourth, the episode is protected by those who are profiting most from it. Now, whether you're talking about fund managers, talking up their book, economists who partake in bubbles, or your next door neighbor, people will rely on their biases to protect ideas that make them wealthy. The second order effects of this are that you get people that maybe wouldn't necessarily fall for these types of euphoric episodes and they end up involved in them. So when the person that you least expect to be invested in an asset is now invested, you are going to be more likely to increase your own conviction and biases in the same idea. Biases in this step include things like dismissing doubts or warnings from others.

Starting point is 00:05:58 Now he reached the end of the euphoric episode and look at the damage that tends to be left in its wake. So the episode always ends with a crash. As Galbraith points out, most of these episodes end with a bang, not a whimper. Now, this means that the participants in the bubble, unfortunately, always lose a lot of money. and very, very quickly. Now, I personally know from experience how quick and painful this step can be, and it's genuinely a brutal experience to live through, so I would like to avoid living through it again at all costs.

Starting point is 00:06:28 Then, after the crash, participants who took part on the way up want somebody to blame for their excessive levels of greed and for losing money. There are always scapegoats who are accused, and sometimes it's valid. But the problem with doing this is that the market just sheds its responsibility for making its own mistake and puts a responsibility onto somebody else. Now, investing is just a risky endeavor. And when it really comes down to it, you and your own due diligence are what I would consider to be the sole factor in your success or your failure.

Starting point is 00:07:01 Last step here is the lull period. The financial memory is shorter than you might think. John Kenneth Galbraith estimates it to last around 20 years, but it can go up and down from that. Now, during this period, people forget about the pains of the past. or new entrants who were never even actually exposed to prior events are now willing to take new risks. And because they're newer to the market, they may have very little experience of what these risks or losses can actually look like and how negative it'll make you end up feeling afterwards.

Starting point is 00:07:33 Now, since capitalism runs on innovation, there's no shortage of new products that will be released that will captivate people, nations, and force their hand at making silly investments. So why is it that I think it's so important to understand these concepts at a deeper level? If we know the anatomy of bubbles and euphoric episodes, I think we can tangibly protect ourselves from participating in them in the future. The more I live and breathe investing and research, other investing legends and events, the more importance that I personally place on long-term survival. Now, a straightforward way to survive is simply to just avoid risking your capital by putting

Starting point is 00:08:09 it into bubble-like assets that could destroy your compounding ability. So I think it's really crucial to take these points very seriously. I like to consider my own positions and maybe spend some time thinking about bubbles that are happening in the market or maybe bubbles that are happening in specific industries that I have exposure to. This is an excellent mental exercise to help you determine where the market is maybe getting frothy. And if you have any exposure to these markets, whether that's direct or indirect, I think it can be really valuable for helping improve your decision making.

Starting point is 00:08:40 So let's dive into this concept of just why it's so hard for investors to use this information effectively and how we might be able to circumvent that problem. Galbraith mentions that the same attributes just keep recurring over and over again and have now for well over three centuries. With that knowledge, it shouldn't really be that hard for investors to take a quick look at the past and figure out how to avoid these euphoric events and try to reduce their risk. The steps to do this aren't overly complicated. But the fact is that only a low percentage of the market has caught on to these speculative episodes,

Starting point is 00:09:14 and there's probably a good reason for that. One of the common attributes of these speculative episodes is what John Kenneth Galbraith refers to as mass escapes from reality. He notes that during these episodes, serious consideration of the true nature of what is taking place is excluded. As a result, the concept of risk is just thrown out of the window with little additional thought until, unfortunately, the bubble pops. Now, the interesting point about bubbles is that they are truly painful, both financially and

Starting point is 00:09:44 psychologically. So if we can assume that the pain thresholds are so high after these events happen, how is it possible that they can continue happening over and over again? So Galbraith says that there are two primary reasons for this. The first one is that the financial memory is shorter than you might assume. And the second one is the inability of market participants to disassociate money from intelligence. Now let's examine each of these in more detail and use some familiar characters in Benjamin Graham and Warren Buffett. So Benjamin Graham lived through the Great Depression

Starting point is 00:10:14 and was very deeply affected by it. Here's a great excerpt by Walter Schloss discussing Ben Graham's experience during the Depression. Quote, Graham was concerned with limiting his risk and he didn't want to lose his money. People don't remember what happened before and how things were. And that's one of the mistakes people make in investing as well. People forget what things were like during the 1930s. I think Graham, because he lived through that period, remembered it, was scared it would happen again and did everything he could to avoid it. But in the process of avoiding it, he missed a lot of opportunities. That's one of the problems that you always have. You don't really lose, but you don't really make either. I believe you should remember what took place,

Starting point is 00:10:57 even if you weren't around at the time. One of the problems of a lot of people who went through the Depression, whether that's Ben Graham, Jerry Newman, and others, is that they keep on thinking that things will always be like that. Even Graham used to say, and quite correctly, that you can't run your investments as if the repeat of 1932 is around the corner. We can have a recession and things can get bad, but you can't plan on that happening. People who did miss this tremendous market. Some people can do it. Most people can't. And I don't think they should try, unquote. So in Graham's case, he thought about risk correctly but probably ended up overweighing it. While he was aware that another depression was potentially around the corner,

Starting point is 00:11:37 he also avoided taking enough risk to identify some of the outstanding opportunities that were ahead of him. Now, we can only hypothesize what Buffett was thinking when he started investing, but we do know he was born in 1930. And by the time he could probably remember anything, his experience of living through the depression were probably very few to none. So he had a much different outlook on how to perceive markets. I doubt Buffett was close to as concerned as Graham was about living through another depression. And because of that, Buffett was able to take his calculated risks, which ended up obviously

Starting point is 00:12:08 doing incredibly well for him. Now, the main point is that the date that you're born will affect your tolerance for risk. I think we will continue to see many bulls in today's age because over the last 15 to 20 years, the markets have been very favorable for equity investors. Now let's touch on the second point about the specious association with money and intelligence. Galbraith says that there's a strong tendency to associate people with money or people who have made money with higher levels of intelligence than they deserve. Galbraith writes, money is the measure of capitalist achievement.

Starting point is 00:12:40 The more money, the greater the achievement, and the intelligence that supports it, unquote. But if we allow ourselves to be biased and equate money with intelligence, then we're putting ourselves at risk. During many of these speculative episodes, the people who do the best tend to have very short track records running the strategy that's currently driving wealth creation. If you follow people playing these short-term games, your ability to assess their risk is going to be very, very minimal. This is why following people into investments into brand-new industries can be so risky. You have to think about the number of possible outcomes. And when you think about, say, new products, there are probably many more potential things that can happen

Starting point is 00:13:18 then will happen. For me, I'm fine watching these kinds of events from the sidelines with a bag of popcorn in my lap. Now let's touch on some of the other biases and psychological tendencies that we see in these euphoric episodes. Finding highly profitable investing opportunities can bring an element of pride. Because of this, the power of social proof and commitment bias tend to come into play. When you're joined by a community of people who are also making fantastic profits, you gain a sense of belonging to the community that is a good. experiencing this success. And as you make more and more money, you can often become more committed to an idea, which makes changing your mind even more difficult. Now, I'd like to finish this

Starting point is 00:13:57 section by expanding on the point I made a little earlier about how when the bubble pops, there are repeatable characteristics of how people react. So the first thing here is that it's not deemed fitting to attribute stupidity to an entire investing community for being wrong or participating in a bubble. A good example of this is when you might have a stock that is not doing well in terms of its price. And then you see all these lawsuits pop up. A friend of mine once referred to these as ambulance chasers. And so these are people that, for whatever reason, are upset that their stock went down and end up trying to sue the company. I have no idea if these are ever successful. But I think that's a really interesting attribute of the market and something to look out for.

Starting point is 00:14:41 So the market is also thought of as being efficient. And because of this, significant price increases generally shouldn't happen. Galbraith calls us a theological reason that speculative mood and mania tend to be exempt from blame. So after many euphoric events that I'll be discussing coming up here, you'll notice that individuals in high places often would take the blame for a lot of these episodes and that the blame was never really taken responsibility by the people that were taking part in these. speculative episodes. So let's get into some examples here that John Kenneth Galbraith goes over in his book. I want to start off here with one of the most popular bubbles of history, which is Tulipomania. So Tulipomania was probably my favorite case study in the book just because it's just so unconventional.

Starting point is 00:15:28 Who would ever think that a flower or a bulb would be an instrument of speculation and euphoria. But that's precisely what happened in the Dutch United Provinces in 1636 and 1637. Interestingly, the tulip had already been in the area for 70 years. It's not like it was some sort of new introduction. It had been growing in interest in spreading the appreciation of the bulb over the years. As Galbraith points out, speculation comes when popular imagination settles on something that seemingly new. And in this case, it was the appreciation and rarity that was found in some of the most

Starting point is 00:16:04 beautiful tulips that you could get your hands on. So in the 1630s, people were buying up these bulbs at alarming prices. This resulted in the typical supply and demand problems that we see in all open markets. When demand far exceeds supply, prices will shift upwards. And that is precisely what happened to the tulips in Holland. In 1636, a bulb was reportedly traded for two horses, a horse cart, and a complete harness. Now, from the looks of it, the bulb looked like a derivative that was used by the masses to find someone else who would buy the asset from them at a higher price in the future. The bulbs reportedly were changing hands multiple times before ever blooming, sometimes 10 times over a day. So for someone to say that they were buying the bulb for the flower, it was probably

Starting point is 00:16:48 pretty dishonest. There was an interesting story in the book about a bulb that ended up going missing and was accidentally eaten by one of the sailors who had imported it. Now, it was said that this bulb that the sailor had eaten was worth around 3,000 Florence. So I went and I researched what a Dutch gilder or a florin would be worth today. So the floren was a physical currency that was made of actual silver. Each coin of that era was made with about 30 grams of silver. So that means that at current silver prices today, each coin was worth about $29.60. Multiply that by $3,000 and you get a value of $88,000. Now, this is just an astronomical amount of money to pay for an asset with a very variable lifespan. But there are obviously other forces at play as to why.

Starting point is 00:17:33 this speculation was happening. But at this time, Holland was the richest country in the world. The Dutch East India Company earned a lot of profits, and these profits had accrued to people who owned shares in the business, and a lot of these people were Dutch. Because of the country's wealth, it was also attracting many wealthy refugees from surrounding areas. And due to the newfound wealth,

Starting point is 00:17:55 many people chose to build just luscious gardens filled with tulips. It's kind of like a societal phenomenon. So during my research, I noted one great article on Tulipomania that claimed that Charles McKay, who wrote extraordinary popular delusions in The Madness of Crowds, a book that was highly referenced by Galbraith, that this bubble was kind of inflated for the sake of entertainment by McKay. So for instance, apparently much of the tulips were not actually bought on leverage. The poorer members of the Dutch society didn't really participate in the speculation. and the disputes that happened in the future market were unenforceable and usually resulted in a settlement that was at a fraction of the original value. So the future contracts that were used to trade a lot of these

Starting point is 00:18:40 were actually regarded as gambling debts. So there wasn't a lot of leverage being used in this particular bubble. So even though Tulipomania wasn't a bubble, maybe that exactly followed Galbraith's framework here, I still think it counts. And, you know, another thing that maybe you'll notice different, than others is that it didn't necessarily leave a large amount of damage after the bubble pop compared to some of the other examples that we're going to go to. Just again, and that was probably

Starting point is 00:19:08 partially because there wasn't as much leverage available to people trading these contracts back then. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from

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Starting point is 00:23:24 So now let's spend some time looking at the next euphoric episode, which concerns John Law and the French Bank Royale. When I read this section of the book, I was astounded at the background of John Law. It's mind-boggling to imagine someone with his background, attaining such a high position in government and finance. But perhaps that speaks to his perceived skill set over his sketchy history. Let's quickly go over his past. So, John Law murdered someone in a duel and was arrested for it. While he was awaiting his trial, he escaped from prison and left the island for the continent. He then made his living as a gambler.

Starting point is 00:23:59 Galbraith writes, his winnings, it is said, were the result of his having worked out the odds in a contemporary version of craps, something that would now have him barred from the tables, unquote. Now, as law grew up, his interest in banking and finance grew. Through his travels around Europe, he noted the success of the Bank of Amsterdam. Law had given some very, very deep thought to the idea of creating his own bank that used hard assets like property and then issued notes that were secured by that property as loans. How the note holders would redeem the land seemed very uncertain and I don't think he necessarily had an answer to that. He brought the idea to Scotland where he was rejected and then he turned his focus to another country, which was France. Now, France at this time was just ripe for this type of financial innovation because they were in a very, very poor financial position.

Starting point is 00:24:45 So King Louis XIV died the year before, leaving two important legacies. One was that the regent of the new King Louis 15th, Duke Orleans. Galbraith amusingly writes that he combined a negligible intellect with deeply committed self-indulgence. And the second legacy was that there was just a bankrupt treasury and numerous unpaid debts from past wars and other numerous extravagances. So France really needed help solving their financial problems and John Law was the person they chose to help them out with that. In 1716, John Law was accorded the right to establish a bank, which would become known as the Bank Royale. It was initially capitalized with 6 million livres. The bank was authorized to issue notes, which it then used to pay current government expenses and take over past debts. The notes

Starting point is 00:25:32 were exchangeable into hard coins if one wished. However, the initial capital needed to be invested into an income-producing asset that was going to be supporting the note issue. So the initial idea was to partner up with the Mississippi Company and the company of the Indies to pursue gold deposits that supposedly existed in Louisiana. Galbraith knows that there was no evidence that this gold actually existed, but because the government needed money, they didn't really care about the facts that supported this claim on the gold. So with this, the euphoric episode began.

Starting point is 00:26:06 Everyone tried to get their hands on the shares. The prices inevitably skyrocketed. Here's how the racket ended up playing out. Quote, The proceeds of the sale of the stock of the Mississippi Company went not to search for as the yet undiscovered gold, but to the government for its debts. The notes that went out to pay the debt came back to buy more stock. More stock was then issued to satisfy more of the intense demand,

Starting point is 00:26:30 the latter having the effect of both lifting the old and new issues to ever more extravagant heights. all the notes in this highly literal circulation were, it was presumed, backed by coin in the bank royale. But the amount of coin that so sustained the notes was soon minuscule in relation to the volume of paper. Here was leverage in a particularly wondrous form, unquote. So, as you can probably tell how this will end, leverage only lasts so long. And bad things tend to happen when someone wants to cash in their shares for real assets that don't exist. So only four years later in 1720, the bubble popped. A prince, by the name of Deconi, was annoyed that he couldn't purchase more of the stock.

Starting point is 00:27:09 So he sent his notes to the bank royale to be turned in for gold. And he was successful with that. Three wagons reportedly lugged his gold back to him. But the region intervened at Law's request and ordered the prince to return all of the gold back to the bank royal. Other people saw that perhaps gold was the direction that they should be moving towards. But Law understood this and orchestrated just a fiendish display to increase the people's confidence in the stock. Here's what he did.

Starting point is 00:27:35 So they hired a battalion of vagrants, equipped them with shovels, and then marched them through the streets of Paris to give the illusion that they were going off on a boat to mine metal in Louisiana. Unfortunately, over the next few weeks, it was proven to be a fiction as people would just see the people

Starting point is 00:27:55 who were not supposed to be in Paris anymore back in the city. So in another event, that was caused by this euphoric episode, 15 people were actually trampled to death outside of the bank royale when note holders ended up learning that their notes were no longer convertible to gold. Unfortunately, the stock price vaporized basically immediately after this event. So after investors ended up losing their money, they were very, very furious and needed someone to blame. Now, the interesting thing here is when you contrast

Starting point is 00:28:25 the perception of John Law compared to the way up and then compared to the way down. So on the way up, John Law was considered a genius. This was a guy with the highest levels of intelligence that were derived from his positive association with money. But when people lost money, they needed someone to blame. And Law was so reviled by the public that he was actually forced to flee the country. After the event, the French economy was depressed for a time, a typical result of speculative episodes. The other interesting part here is that the people who partook in the successive speculation didn't blame themselves. They blamed John Law.

Starting point is 00:29:00 Now, this is an interesting case study here because I think it just goes to show you how little due diligence was being done by both the note holders and the shareholders in this example. So perhaps it's easy for me to say this in hindsight, but you would think that maybe the note issuers or the shareholders would try to reach out to people who actually mine gold or sailors who went there to try to get some grasp of what the actual situation was. in terms of if the company was actually making money or not. But I think the absence of this due diligence is kind of the scary part about a lot of these episodes. And you'll see it more as I discuss other examples in this episode. But, you know, when you're making money or when things just look really, really good, it blinds you from asking the tough questions.

Starting point is 00:29:49 And, you know, these are the times where these tough questions are probably the most important to ask. Now, another important lesson here is to make sure that you're putting your trust in the right person or organization. Now, this whole setup would be seen as a complete fraud today. It would be very hard to execute anywhere in the world. If you have an inkling of doubt about the people that you're doing business with, I think that's more than enough of a reason to just walk away from a potential deal.

Starting point is 00:30:15 And when you think about the type of person that John Law was, I can tell you that he's by far the furthest thing away from a person that I would actually entrust any of my money to. Now let's turn our attention to another bubble that happened around the same time as a Mississippi bubble, which was the South Sea Company bubble. So the South Sea case study was very, very similar to the bank royal event. They both were seen as kind of these innovative ways to reduce government debt. Now the innovation in the case of the South Sea bubble was called a joint stock. So basically in return for the charter of the South Sea company, it would take over the government's debt and in return was paid about 6% by the government and also had the right to issue stock.

Starting point is 00:30:58 So the book has this massively vast land that the South Sea company claimed. It was basically, obviously, the U.S. didn't exist back then, but imagine the southern U.S. all the way down to the bottom of South America. So it was an unfathletable amount of land, which they could then trade goods and slaves. But at loss in this claim was that Spain had claimed essentially the exact same land. However, with most bubbles, these very, very essential facts are often overlooked. when greed tends to be involved. Now, as more stock was purchased, the South Sea Company eventually assumed all of the public debt.

Starting point is 00:31:37 Here's how the stock moved just in 1720. In January, it was 128 pounds. By March, it went up to 330 pounds. In May, it went to 550, 890 in June, and to around 1,000 later in the summer. So this is about an eight beggar in eight months. And, you know, this isn't necessarily unusual. if you watch stock market long enough, you'll see things like this happen yearly, I would say.

Starting point is 00:32:04 But the really remarkable part about this was that the South Sea company wasn't actually generating profits. The returns in the market were generated purely by euphoric market participants whose demand for the stock far exceeded the supply. So in common terms, I guess you could just think of it as a multiple expansion of, I don't know, even know what they would have used back then, seeing as there was no actual profits. And if there are no profits, I would assume there would not have been any revenue either, but that's how you can kind of think of it. Now, while this bubble was reaching its crescendo, there were copycat companies that were just coming out of the woodwork to try and

Starting point is 00:32:40 take advantage of the market's positive mood. Galbraith writes, quote, these included companies to develop perpetual motion, to ensure horses, to improve the art of making soap, to trade in hair, to repair and rebuild parsonage and vicarage houses, to transmute quicksilver into malleable fine metal,

Starting point is 00:33:00 and to erect hospitals or houses for taking in and maintaining illegitimate children. If you pull up a chart of IPOs, you'll see them exploding during what looks to be euphoric times. And it's easy to see why. So when money is flowing into the market, businesses know that they can get a premium for their stock if they choose to go public. So during these times, you'll often see the rate of IPOs explode.

Starting point is 00:33:25 Now, as an observer, this is also probably a very good signal that you're not going to get excellent prices for shares in a business. So if you see IPOs expanding, it probably means that you should be extra prudent during these times. If you look at a chart of IPOs in the last 20 years, the highest numbers of IPOs was in 2021, the year after COVID-19. So if you look at 2020, the market returned about 16%, and in 2021 it returned about 27%. So you can tangibly see that private businesses were probably also noticing that returns were really high and they were trying to take advantage of it. But let's get back to the South Sea bubble here. In July of 1720, the government called a halt to these copycat companies with this new legislation that they aptly named the Bubble Act. This put a stop to the copycats and also attempted to stop capital outflows that were going from the South Sea company to other stocks.

Starting point is 00:34:23 unfortunately it didn't work. And by September, it was down to about 175 pounds, and by December, it was down to 124 pounds. Now, after the bubble popped, there was the usual need for somebody to blame. Here's a list of what happened to some of the innovators of the joint stock company or other higher-ups that were involved. So you had Sir John Blunt, who narrowly escaped death when an assailant literally tried shooting him on the street. He later saved himself by turning himself in.

Starting point is 00:34:49 Other individuals were expelled from parliament and had their money and estates, confiscated to provide compensation to some of the shareholders who had lost money. The treasurer of the South Sea Company fled and was pursued on the continent. He managed to escape and lived in exile for the next 21 years. James Craig, who was an influential elder statesman on the affair, ended up committing suicide, and many other people ended up going in prison. So Galbraith sums up this event very well. Quote, there was large leverage turning on small interest payments by the Treasury on the public

Starting point is 00:35:22 debt taken over. Individuals were dangerously captured by belief in their own financial acumen and intelligence and conveyed this error to others. There was an investment opportunity, rich in imagined prospects, but negligible in any calm view of reality. Something seemingly exciting and innovative captured the public imagination. In this case, the joint stock company, although as already noted, it was of decidedly earlier origin. The great chartered companies trading to India and elsewhere were by now a century old. And as the operative force, dutifully neglected, there was the mass escape from sanity by people in pursuit of profit. Now, one of Isaac Newton's famous quotes is, I can calculate the movement of stars, but not the madness of men. And this quote was a product

Starting point is 00:36:08 of Newton's experience with this bubble. He'd actually owned the shares years before the bubble formed. And when the bubble was beginning to form, he correctly assumed that it was a bubble and that he should exit his investment. And he did just that and he actually made a really nice profit. But unfortunately, due to, you know, our own misjudgments and greed and social proof, he was pulled back in to buying the stock near the top and ended up losing his money as the bubble burst. So I love this example so much because Isaac Newton is regarded as one of the smartest people ever to walk the face of the earth.

Starting point is 00:36:44 And it just shows you that intelligence is meaningless. when it comes to the world of investing. Now, the next chapter, I'm not going to go into too much detail, but it's called the American tradition, which is a title I find kind of humorous. So I'll just outline some of the smaller bubbles that happen in U.S. history that might not get as much attention, say, as the Great Depression.

Starting point is 00:37:07 So let's go back to 6090. There was an expedition that was led to capture a fortress in Quebec. Once captured, the goods inside of the fortress were intended to, actually pay the soldiers who were attacking it. But unfortunately, the fortress didn't fall. So the colonial treasury had no gold or silver to spend and give to these soldiers for their time. So its solution was to issue paper notes with the eventual promise that the notes would one day be convertible into silver or gold. There were also numerous bank runs that were caused by some pretty big bubbles and things such as land canals and turnpikes. About a decade later,

Starting point is 00:37:47 these bubbles were forgotten, making room for new bubbles that were caused by innovations and leverage. So when it comes to leverage, the banks in the U.S. were required to hold reserves of hard coins against their outstanding notes. But regulators didn't do a very good job of enforcing these rules. So there's an excerpt here from the book. At the outer extreme of compliance, a group of Michigan banks joined to cooperate in the ownership of the same reserves. These were transferred from one institution to the next in advance of the examiner as he made his rounds. And on this or other occasions, there was a further economy. The top layer of gold coins in the container was given a more impressive height by a large layer of 10 penny nails below. Clearly, these reserves that banks were required

Starting point is 00:38:34 was more of a suggestion and a lot of people just were fraudulently working themselves around it. So one bank in New England had to end up closing. And they had about 500,000. dollars of notes outstanding and a specie reserve of only $86.48. And last to here, you know, after the Civil War, railroad stocks had this big bubble. In 1873, two very large banks went under and the New York Stock Exchange actually had to close for about 10 days. But let's fast forward to the 1920s and discuss the Great Depression because that's an area where John Kenneth Galbraith is very, very passionate about. So the Great Depression ticks nearly all of the boxes of Galbraith's classic Euphithe. work episodes. So from the last section where we discussed leverage, banks have a long history

Starting point is 00:39:20 in the U.S. of using it to their own advantage at the expense, unfortunately, of their depositors. However, in 1929, the use of leverage further spread not just from the banks, but also to the participants in the stock market. And because stock market participants were able to get this leverage, it helped boost public equity prices. So as early as 1924, stocks began rising and continued to do so with just a small drawdown in 1926. After that drawdown, continued going up. And as Galbraith points out in 1928 and 1929, the stock market left reality.

Starting point is 00:39:56 So another lull in the euphoric mood happened around the spring of 1929 when the Federal Reserve announced that they're actually thinking of tightening interest rates specifically to help slow down the booming stock market prices. Now, the head of the National City Bank, Charles Mitchell, said he would lend money to the public to offset any damage that was created by these increased interest rates by the Fed. After Mitchell made the statement, the euphoria returned. And the market increase in the following three months after he made the statement actually exceeded that of the entire previous year.

Starting point is 00:40:28 Let's talk a little bit about margin because it was innovative then and many economists actually partially blame the ease of leverage as a catalyst for the Great Depression. So leverage in the 1920s work like this, which isn't too dissimilar to how it still works today. You could buy a stock at, say, 10% of its purchase price using margin. 10% of the stock belonged to the purchaser and 90% of the stock belonged to the lender. The crazy part here is the interest rate so on this margin loan. They were expensive. They ranged from 7% to an absolutely obscene 15%. So I don't even know how people made this work, but I guess it did work because of just how fast stock prices were going up. So as is common in these euphoric episodes,

Starting point is 00:41:08 intelligence is attributed to those who are helping participants make money. So Irving Fisher was the kind of prominent economist of the time, and he was involved in the market. So his incentives lay in propping the market up, not necessarily in sounding the warning alarms of a heavily overpriced stock market. In the autumn of 1929, he said, quote, stock prices have reached what looks like a permanently high plateau, unquote. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:45:10 and Goldman Sachs knew that. So let's say a fund could be sold for, let's say, 50% more than its net asset value. Then, with that knowledge, fund promoters could actually double their profits when the top of the pyramid owns another fund, which owns stocks rather than just buying new stocks itself. So here's kind of how it worked with Goldman Sachs. They had this trading corporation, which was at the top of the pyramid. Now, the trading corporation had an extensive ownership of another fund called the Shenandoah Corporation. The Shenandoah Corporation also understood how this worked. So they then organized another fund that they owned called the Blue Ridge Corporation.

Starting point is 00:45:47 So all of these funds traded at a premium to their asset value and would therefore confer the most amount of value to the top, which was the Goldman Sachs Trading Corporation. But October 21st ended one of the most significant euphoric episodes in history. Starting that week, cracks in stocks began to open. By the following week, the floor had broken out from under the market and forced selling to cover margin loads, which helped fuel additional downward pressure. Bankers with, bankers with large amounts of capital were exiting the market, causing further panic. Like most other euphoric episodes, individuals were blamed by,

Starting point is 00:46:22 by those who lost money for participating in the speculation. So Charles Mitchell, the banker, who I previously mentioned, he was sacked. The head of another prominent bank, Albert Wiggin, was sacked and also denied his pension. Other promoters were called in front of congressional meetings. Another prominent investor, Witcher Whitney, went to prison for embezzlement for bonds. And the prominent economist Irving Fisher, who I mentioned, he wasn't necessarily blamed, but he lost a lot of money. And luckily, his alma mater, Yale,

Starting point is 00:46:52 helped rescue him to some degree. Now, the interesting thing about the Great Depression was that it had just a massive, massive effect on the world economy. So between 1929 and 1932, the worldwide GDP dropped by an outstanding 15%. International trade dropped 50% and U.S. unemployment rose to 23%. As a result of all of this, the stock market didn't move for a quarter of a century. So now I want to turn to three more euphoric. episodes from more recent times that I think much of the audience is going to be very familiar

Starting point is 00:47:27 with. So the three that I want to talk about here are the tech bubble, the great financial crisis, and just some smaller bubbleish areas that happen in specific industries after the COVID boom. We'll start with the tech bubble. So the tech bubble was a massive bubble that started forming in the 1990s based on the back of the internet. Let's look at this bubble specifically through Galbraith framework. So the first thing we see is a very exciting and innovative development, which was the internet.

Starting point is 00:47:58 This bubble has also been referred to as the dot-com bubble due to some of the craziness that happened in terms of just changing the names of your company. I'll discuss that more shortly, but the internet was hailed as this next game changer. And that euphoric attitude brought tons and tons of capital into the market. Now, the interesting thing about the internet is that it truly was a game changer. All the largest businesses today, like Amazon, Microsoft, Google, and Apple probably would never have gotten to where they are today without the internet. The problem was that in the 1990s, the infrastructure needed for widespread use cases just wasn't there. It was very ahead of its time.

Starting point is 00:48:35 But as you have probably noticed with some of the previous bubbles, notably the Bank Royale and the South Sea Company bubble, investors tend to ignore the facts and focus on the potential returns that they can make. So it's referred to the dot-com bubble because many businesses, were just adding dot com to their names and then going public simply because they knew that they could ride the wave of the internet to pop up their share prices for a time. So the poster of this, I think, is pets.com. So pets.com was an online retailer of pet supplies. And, you know, when I think about this, it's a good idea.

Starting point is 00:49:08 I mean, I bought tons of things for my dog online. But, you know, things have changed a lot since 2000. You know, back then, there was only about 250 million internet consumers versus five billion today. And then on top of that, the costs of running an online business were just way higher today. And that was unfortunately part of the downfall of Pets.com. So Pets.com went public at about $11 per share. And over a few short months rose to $14. So it wasn't even a huge run up here. But it's the rundown. That's the scary part. So in the first nine months of 2000, and if you looked at the company's income statement,

Starting point is 00:49:48 lost $150 million. So the share price, as a result, then sank very quickly to about a dollar and then dropped to zero as the company went bankrupt. So during the tech bubble, you know, many people believe that investing in these overpriced tech names

Starting point is 00:50:03 meant they had above average intelligence. There were retail investors who were following Wall Street into some of these bubble-like deals. And when everyone's making money, it can be easy to think that you found this, you know, a cheat code for making money. And as a result, many people were piling their life savings into tech stocks believing that they would never stop going up.

Starting point is 00:50:21 Leverage was also used at this time. Interest rates had declined steeply since their highs in the 1980s. And due to low-cost debt, there were startups that were proliferating as well. Venture capitalists wanted a piece of the action as well. Retail and institutional investors sought to use margin to juice every percent of potential return from buying stocks. Now, as the bubble started forming people profiting from it protected their ideas at all costs. These protectors included people like tech company executives protecting their options or the shares that they owned, venture capitalists, and even stock market analysts who are quick to justify high valuations. Now, one of my favorite psychological misjudgments is the contrast misreaction tendency.

Starting point is 00:51:02 So the tendency is to contrast things in relation to things that we have experienced in relative terms rather than absolutes. I think this tendency speaks volumes, especially in speculative manias regarding values. So when comparing one business to a basket of other companies that are in a bubble, you're very likely to see something as maybe being cheap when everything else is expensive. Let's say one thing is training a PE of 50 and everything else is a P.E. of 100. So this can cause an investor to think the P.E. of 50 is cheap erroneously. So I think when you're comparing evaluations during more euphoric times, not even necessarily a bubble, but just more euphoric times, you need to be careful about the comps that you're making. Because sometimes if you're comparing to an industry that is as a whole overpriced, you can get burnt pretty bad.

Starting point is 00:51:53 Now another aspect of the tech bubble was the newly formed metrics that were used to justify ever increasing valuations. These metrics were just kind of made up at the time. So these things were like eyeballs and clicks. and these metrics carried a lot of weight, more weight than what was used traditionally, such as revenue or profits or things that we still use today. But as, you know, with all euphoric episodes, they end with a bang. And in early 2000, stock prices violently collapsed. So the NASDAQ dropped 78% from peak to trough in 2002.

Starting point is 00:52:27 There were multiple reasons such as increased bankruptcies, frauds, and potential increased rate height scares. But at the end of it, it was. just a heavily overpriced market that was ripe for a correction. Now, after the crash, many investors were left with the pittance of what they had originally invested. And they were upset. So in this case, the blame went to a variety of people other than themselves. They blame the dot-com companies themselves for being overly optimistic. Maybe these companies were mismanaged and some of them were even misleading. Some very well-known investment groups, such as Citigroup and Merrill Lynch, were hit with some pretty hefty fines by the

Starting point is 00:53:04 SEC for misleading investors. But, you know, despite this large and painful euphoric episode, the financial memory after this bubble was very short. And just around the corner was the mid-2000s. And during 2008, another euphoric episode was brewing, which was the Great Financial Crisis, which we'll talk about now. The Great Financial Crisis is an event that I think will hit home for many listeners of TIP. It happened in 2008 and most definitely has many of the qualities that are found in Galbraith's framework. So let's start a little bit here with the background. of the event. So the housing boom started in early 2000s.

Starting point is 00:53:38 And this boom was the result of a few things. There were two new innovative financial products, mortgage-backed securities, which I'll refer to as MBS, and collateralized debt obligations, which I'll refer to as CDOs. Now, I'm not going to get into the details of each of these financial products because I would take a long time. And to be honest, I'm not sure I even understand them very well, despite watching the big short numerous times, which has a pretty good job of trying to explain what they are. Now, these instruments basically allow banks to bundle and sell mortgages to investors.

Starting point is 00:54:11 This supposedly spreads risk and injects liquidity into the lending markets. At the time, it was seen as an innovative way to make homeownership available for more American citizens. But you can also look at this as an updated form of the joint stock companies that we discussed three centuries ago. One party owns a risky asset, bundling it into a low-risk safe security, and then selling it to the public. However, as we learn in the bank royale and cell C company case studies, the security was not so secure. Another poorly utilized financial product before 2008 was what was called a Ninja loan. So Ninja was an acronym for no income, no jobs, and no assets.

Starting point is 00:54:50 The mortgage brokers handed out loans to pretty much anyone with barely any qualification actually needed. To give you an idea of the salaries of some of the people who are getting these ninja loans, let's look at an excerpt from Michael Batnik's great book, Big Mistakes. which, by the way, my co-host, Clay, discussed on TIP 579. So Batnik writes, quote, if you wanted a mortgage in 2005, all you had to do was ask for one. In one instance, a mariachi singer claimed to have a six-figure income,

Starting point is 00:55:16 and despite having very little knowledge of what such singer earned, the lender agreed to the loan. In lieu of official proof of income, it included a photo of him in his performance outfit. Alberta and Rosa Ramirez, strawberry pickers, earning $300 a week, pulled their resources with another couple, mushroom farmers who earned $500 a week. Together with a combined salary of $3,200 a month,

Starting point is 00:55:40 they got a mortgage for $3,000 a month. Strawberry Pickers, who earned $15,000 a year, qualified for a $720,000 mortgage. This was the bubble in a nutshell. Now, by 2005, $625 billion of mortgages were taken out by subprime borrowers, a fifth of all home mortgages that year, and 24% of all mortgages were originated without the borrower putting any money down. So leading up to the crisis, many millionaires were made, and housing prices nearly doubled

Starting point is 00:56:13 between 2000 and 2006. Homeowners at this time were seen as intelligent because they were seeing their property go up in price much faster than historic levels. Banks, rating agencies, and institutions all felt that the risk was properly distributed and that their financial products were in good shape. People in finance felt that a new paradigm shift was happening where profits could be had with minimal risk. Now, leverage was a very big part of the great financial crisis.

Starting point is 00:56:39 Real estate is a highly leveraged industry by its nature. Most homeowners buy their houses using a mortgage, which are essentially just loans on the price of the house. U.S. private debt surpassed 250% of U.S. GDP. Now, I went and looked at the leverage ratios for some of the major investment banks between 2003 and 2007. Essentially, all of them had a linear line going up and to the right as their leverage ratios skyrocketed.

Starting point is 00:57:04 The leverage ratios here are defined as total debt divided by stockholders' equity. But this was true for Bear Stearns, Goldman Sachs, Merrill Lynch, and Morgan Stanley. Financial institution, like these banks, issued large, large amounts of debt during this period. The proceeds from this debt were then invested into things like mortgage-backed securities. But the banks had large bets that housing prices would continue. you to rise. And finally, there was a massive amount of protection going on for the real estate, given how many people were profiting from it. Financial ratings agencies gave AAA ratings to MBS and CDOs, even though the underlying assets were increasing at risk as property prices

Starting point is 00:57:45 continued increasing and unfortunately defaults were growing at the same time. Financial institutions actually downplayed concerns of a bubble that were happening in the real estate market. And just like in some of the other euphoric episodes that I've already mentioned, when people are making enormous profits, they aren't asking the difficult questions. And even if they did, they probably wouldn't want to know what the answers are to them. So in 2007, 2008, the collapse came. Home prices began falling and these overly complicated financial products began their precipitous decline. Now, the value of MBS and CDOs cratered. The loss on these financial products were what really did the system in.

Starting point is 00:58:21 major financial institutions like Lehman Brothers and Bear Stearns went bankrupt. AIG required massive bailouts by the government to stay afloat. The stock market collapsed, global credit markets froze, and the world entered a recession. Now, as for the scapegoats, there weren't many, even though people were clearly very distraught. You know, people in this event lost their homes. It wasn't just the rich losing a small fraction of their wealth. But people ended up blaming a multitude of different things. So people blamed subprime mortgage borrowers who,

Starting point is 00:58:51 couldn't afford their mortgages, the ratings agencies, regulators, central banks, Wall Street, major banks, and investment firms. But after the great financial crisis, like most bubbles, financial memories are short. So even though I don't think anything as big as the great financial crisis has really happened since then, in my opinion, you can argue that there have been many smaller bubbles, which have occurred, which is what I'm going to finish this episode with. So the post-COVID boom showed some bubble-like qualities in a variety of industries. So the three industries that I want to talk about here briefly are tech stocks, electric vehicles, and artificial intelligence. Now, from the bottom of COVID to the market top for the NASDAQ, the index appreciated from about $6,800 to $16,000 in just a year and a half.

Starting point is 00:59:38 Now, this was driven by fundamentals. Some of these businesses were getting better. But, you know, there obviously was some speculation involved here as to why prices rose up so sharply. So one business that I owned during this time, which was actually in the NASDAQ, so the name might be familiar to you as Tobias Carlisle pitched it on Stig's Q4, 2023 mastermind calls back on TIP 586. This business had one of the quickest price appreciations of any business that I've ever owned.

Starting point is 01:00:07 It was about $8.63 at the depths of COVID, and I went all the way up to about $94.74 at its all-time high on October 29th of 2021. an incredible 11-bagger in a very, very short period of time. So during that short period of time, the business got better. Percia earnings doubled, so the business was getting better, but 11 times better, don't know about that. At the same time, who could forget about the electric vehicle bubble that formed around Tesla's success? I don't think Tesla is necessarily the best example of peak speculation because similar to

Starting point is 01:00:40 in-mode and other high-quality tech games, the business was getting better back then. where the bubble occurred in EV, I think, was in some of the lower quality names. So a fascinating thing happened in the stock market that all participants should be aware of. Basically, when one stock, such as Tesla, does very well, it often has a gravitational pull on adjacent businesses that are in the exact same industry. So you get managers of other companies that know this, and they're going to try to take advantage of it. I already spoke with a tech bubble of 1999 when many managers attempted to take advantage of this

Starting point is 01:01:10 by adding just dot com to their names. but in EV, the poster child of this bubble, happened to be a business called Nicola. Nicola made claims that were just unfortunately too good to be true. Their founder, Trevor Milton, who's now a convicted criminal, claimed they had built the world's first fully electric truck, fully from the ground up. They also claimed that they had built their batteries, even though literally nobody was buying them. And this call made it in the Nicola 1 semi-truck that he passed as a vehicle that worked.

Starting point is 01:01:42 the vehicle did not work and he knew it. So if you look at EVETFs, which I didn't even know existed until I researched this episode, you'll see that they actually peaked about a year or so after the Nicola stock peaked in June of 2020. Nicola had a stratospheric return going from 310 in February of 2020 to $2,205 in June of 2020. Stock now trades for $3.80. So are there bubbles forming right now? I would say probably, but I'm not necessarily sure. where they are. Market pundits have written much about how AI is a bubble, but kind of, I'm not sure

Starting point is 01:02:19 I see it myself. While I think there are many businesses that are associated with AI that are expensive, there's also many AI businesses that are just really good businesses that deserve premium evaluations. Businesses like Google and Microsoft come to mind. What I would say is that AI is very popular these days. And, you know, what is generally prevalent in the lay press is definitely not associated with cheap stock prices or outsized returns. So many investors may claim that I should look at Nvidia as proof that I'm wrong about the return statement, but I have a retort to that. I personally know investors who have lost a lot of money on Nvidia.

Starting point is 01:02:55 They speculated on the price of Nvidia going up, bought the top, realized it wouldn't continue going up indefinitely and then unfortunately sold out at a loss. Regardless, I still don't think Nvidia is necessarily a bubble stock, but I also personally wouldn't own it, nor do I have any plans to own it in the future. I'm fine, just watching how it plays out from the sidelines, the same way I do with 99.99% of the other stocks in this world. Now to finish this episode, I want to cover some of the biggest takeaways from a short history of financial euphoria that I think are going to be very useful and usable.

Starting point is 01:03:26 I have six primary lessons I learned from the book, as well as some reflections on my other notes on bubbles and dealing with financial euphoria in general. So number one is that bubbles should be expected. A value investor who runs below the radar that I highly respect is named Nick Train. He's been compounding capital at about 9.5% for 25 years. So he's lived through many, many of the later booms that I've discussed in this episode. Now, he had a great insight into market manias. Quote, booms and busts are integral to markets.

Starting point is 01:03:56 And without them, they can't do their job. Namely, finance new ideas. We pejoratively describe booms as manias, suggesting that individual investors have become irrational, carried away by greed. This may be so. but at societal level, these manias are in fact quite rational and beneficial. We wouldn't have Facebook and Google without the mania of 1997 to 2000, unquote. Now, this is a fascinating line of thinking. If you agree with Nick Train, then it means that credit systems should not be set up to avoid bubbles.

Starting point is 01:04:29 Bubbles are actually a feature of a thriving capitalistic system. But that doesn't mean that each investor can blindly invest capital in whatever idea is the flavor of the day. The tech boom, while disadvantageous to many of the investors who buy out the top, was possibly advantageous to society as a whole. If you buy things online, use Google search engine or enjoy catching up with friends on Instagram or Facebook, you have the internet bubble to thank for that. The trick is investing in a way that allows you to bypass bubbles as often as possible, which brings me to point number two, which is how to avoid losing money in bubbles.

Starting point is 01:05:03 So Howard Mark says refusing to join is actually the key to avoiding losing money in bubbles. Now, this is easier said than done. But Marx makes the point that greed and human error cause over optimism while simultaneously making you ignore some of the more obvious negatives. The one tool that I like to use to combat bubbles is to just avoid owning stocks that appreciate quickly in price. So this seems like a silly thing to say, but bear with me here. So you have to remember the importance of certainty. We want a high certainty of a gain and a low certainty. of a loss. So getting 15% at high certainty to me is actually probably more attractive than getting 100% at very low certainty. The reason being that if I think I can get 15% nearly

Starting point is 01:05:50 guaranteed, I'll take that over getting 100% where it's the 10% chance that I get it and you know, a 90% chance I lose all my money. So that's personal preference, but that's just how I see investing. Another thing you can do is just look at position sizing. So I think as you invest, you learn more and more about yourself, self-reflect. And if you must speculate, then just do it with very, very tiny portions of your portfolio. And do not use leverage in that area of your portfolio. Now, there's also the role of comparing yourself to others. So unfortunately, you're going to be just playing a losing game if you're comparing

Starting point is 01:06:28 your stocks to stocks that go up faster than your own. You'll never win this game simply because there will literally always be a stock that's out there performing better than one. what you already own. So in the stock market, as in most areas of life, I think at least I want to play games and create my environment to partaking games that I think that I have a very good chance of winning it. And the next thing here is if you make bad decisions because you do certain habits that you think you can identify and can get rid of, then you should probably try to spend some time improving your environment. So one specific thing that I like to look at is looking at stock prices.

Starting point is 01:07:03 I know, at least for me, when I first started investing, I would look at stock prices an embarrassingly large amount of time. And it would cause me to just be happy or sad based on what the stock price were doing. And I just figured that was just not a good way to live life. And so I deleted the app and that helped a lot. Weeks would go by and I'd have no idea what the stock price was and I found that very beneficial. Now, I will say full transparency, I have the app back on my phone.

Starting point is 01:07:29 I definitely check it a lot less. But now I think I'm at, a point now where I understand myself and it just doesn't bother me that much that I don't care if it goes up or down if I feel I understand the business. So Warren Buffett has said that we should treat our stocks like private businesses where we assess our performance based on the fundamentals of the business and not necessarily in the stock price. And I think this is actually one of the best ways to also avoid bubbles. So if you assess a company and not the stock, you'll find just these massive discrepancies in value and price. And so when you focus some of your time and

Starting point is 01:08:01 effort here, you're going to realize that taking part of investments where price far exceeds value is just a recipe for failure. So focus, focus, focus on deep due diligence and value. This is a good segue into point number three, which is why we should always remember risk. So there's kind of this inverted correlation between risk and euphoria slash depression in the market. So when the market is most euphoric is actually probably when we should spend the most time thinking about risk. And when the market is most depressed is when we should probably spend less time thinking about risk and more time deploying capital. But in reality, it doesn't work that way. When markets are euphoric, people don't think about risk. And when markets are depressed,

Starting point is 01:08:42 everyone thinks only about risk. So I think that's something to keep in mind. So as I mentioned previously here, price will always matter, no matter the quality of the business. I know many of my co-hosts on this show share in my appreciative high quality businesses. We are always aware of the price that these business are trading at and what we might want to pay to lower our downside and increase our upside. Now, the most significant error I see in euphoric markets is mistaking current growth rates into perpetuity. I know I made this mistake myself. Alibaba is an excellent example of this mistake that I made. So I bought Alibaba back in 2020. And I just looked back on FinChat and looked back at the years leading up to when I first bought it. And at that point, they were growing profits at 44% compounded

Starting point is 01:09:28 manually between 2015 and 2020, a very, very high number. Now, going into it luckily, I actually didn't assume that it would continue growing at that. I pretty much gave it a 50% haircut, brought that growth rate down at 22% going into the future, which I felt would give me more realistic number and a margin of safety. But now I looked back at it from 2020 to present, wanted to see how net income had compounded. And basically, it's gone down minus 60. 15% compounded annually. So, you know, these are this types of mistakes that I know I've made in

Starting point is 01:10:04 the past, I'll probably make in the future and other investors make. And I think even the best investors make this mistake. And so, you know, the best way here to probably combat these mistakes is to try to use realistic growth rates and really spend some time learning if current growth rates are the result of short-term tailwinds or if current growth rates are likely to happen for long periods into the future. These short-term tailwinds can be a death sentence for investors when you mistake them for long-term tailwinds, as unfortunately I did. So if you see just a few short years about outstanding growth, I think you need to really

Starting point is 01:10:39 ask yourself how certain you are that these will be sustainable into the future. Shaving a significant percentage from the number will probably be the best way to protect yourself. And hey, even if you're wrong and your number is far below reality, then you'll have some untapped upside. So number four here is the general concept of overpaying. This goes hands in hand with the point I made above about risk. There are simple ways to observe how much risk is embedded in the market.

Starting point is 01:11:04 So a couple of things that I like to do. Just look at how much of the index has appreciated. If you're a U.S.-based investor and you own individual stocks, you can look at the S.S. 500. You can probably see if it's gone up a lot lately or gone down a lot lately, and that will give you some sort of sign if you're going to be overpaying or not. Another thing you can do is look at your own portfolio and see if you'd be willing to add to the positions that you currently have at the current prices or if you'd want to wait.

Starting point is 01:11:29 So if you look at your total whole portfolio and you're like, oh my goodness, like these all look like excellent opportunities, well, then that's probably a good signal that the market is cheap. But if you look at your portfolio and you're like, ooh, these all look expensive. I don't even know if I want to keep these. Well, then that's probably a good signal that the market is overpriced. It's also important to remember that just because there's a bull market in one year of the market doesn't mean that there's a bear market elsewhere. So a good example of this was last year in 2023. U.S. large caps were doing really, really good.

Starting point is 01:11:59 But I noticed that in small caps were in the mud. And I invest in a lot of those and they've tended to do quite well for me. But, you know, if you look around enough, you can usually always find some sort of deal, but you may need to invest outside of your own country in order to find these types of advantages. Now, the important thing here is that there isn't a blueprint for avoiding overpaying. You just need to do your own due diligence on a business. You need to determine its value and you need to compare the value and the price. If the price far exceeds the value, that's a good signal that you should just skip it or practice some patience and wait for price to be far below value.

Starting point is 01:12:35 Now, I know how hard this can be. Let's say you find an idea, spend 20, 30, 40 hours researching it and you really like the business. but when you crunch the numbers, they just aren't attractive. And so, you know, I've had that feeling where it's like,

Starting point is 01:12:51 oh, I like this business. I just did so much work on it. I wanted in my portfolio. But I think the right move is to be as rational as possible. You know, you're going to save yourself and partaking in potential bubbles. And, you know,

Starting point is 01:13:02 if you do your due diligence and find out that a business is really, really good, there's a very, very good chance that it'll come out of favor sometime in the future and you'll get a better entrance price then. So the fifth one here is, establishing a coherent selling framework. So selling is one of the most difficult parts of investing. And it's really important to understand that selling just because your stock is overpriced is

Starting point is 01:13:24 definitely not the same as selling when your stock is in bubble territory. So if you're a long-term investor, then selling because a high-quality stock is overpriced is definitely a mistake. But if you're also a long-term investor, selling when a stock is in a bubble is not a mistake. So you as an investor kind of have to delineate how you define each of those. It's not that simple. I'll tell you a little bit of how I do it, but basically what I look at is trying to figure out how far forward a stock price is being pulled. So, you know, for me, if a stock price is pulled forward five years, my kind of default is to exit that investment. You listening to this might prefer a shorter period and you might prefer a longer period. And that's perfectly fine. It's all about individual preferences.

Starting point is 01:14:11 and my way of doing it's not right and it's not wrong. And your way of doing it's not right or wrong either. It's just your own preference. So I think the insight here is that you just need to maintain your selling criteria. Obviously during these euphoric episodes, it's easy to get greedy. And in that case, if you're getting greedy, you might then say, oh, well, stock XYZ has been pulled forward five years, but you know, like, oh, it looks better. Let's wait for 10 years to be pulled forward.

Starting point is 01:14:37 And if you become undisciplined in that sense, you might see some pain. You might have a couple successes as well, but I think discipline probably is the best course here. So the last one here, number six is the importance of taking responsibility for your investments. So, you know, when we think about the stock market, we're lucky enough that we can invest and it's our choice to invest. We can choose to invest and we can also choose not to invest. nobody is actually forcing us to invest or do anything with our money here. So if I personally make a choice to invest into something and let's say the CEO turns out to be a con man, yeah, I'm going to be very upset.

Starting point is 01:15:20 But at the end of the day, I can only really blame myself for not doing as much work as possible to try and find as much information as possible. It's kind of a tough one because if a CEO inside of a company can lie, to his employees and how is a investor ever going to know as much as an employee? And I don't really have a good answer to that. But I think where I'm coming from this is through the lens of, you know, if you're losing money in the market, you can't just go around blaming other people all the time. And because doing that's just kind of pointless, especially if you're a stock picker.

Starting point is 01:15:57 Because think about it, if you blame other people for your losses, then you need to also not blame yourself for your wins. And in that case, then what's the point of investing in individual stocks? You're basically saying that you cannot discern between a winner and a loser. In that case, you're basically just throwing darts. And you probably are going to be better off just investing into a index. So that's all I have for you today. If you want to interact with me on Twitter, please give me a follow at Irrational MRKTS or on LinkedIn.

Starting point is 01:16:24 And if you enjoy my episodes, please feel free to drop me a line. And please just let me know how I can make your listening experience better, how I can improve my episodes or interesting things you'd like for me to talk about. So thanks again so much for tuning in today and I look forward to talking to you again soon. Bye bye. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com.

Starting point is 01:16:55 This show is for entertainment purposes only before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP673: A Short History Of Financial Euphoria w/ Kyle Grieve

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