Learning to Love Investment Bubbles | #24

Episode Summary

Executive Summary: Meb Faber explains a white paper on why investors should understand and sometimes “love” bubbles: they are recurring, behavior-driven manias that can destroy capital. Using South Sea as the historical centerpiece, he argues that a simple 10-month trend-following rule could have reduced drawdowns and volatility across major bubbles, helping investors survive extreme crashes and preserve capital.

Main Topics: What defines an investment bubble (Priority: 5/5): Faber frames bubbles as periods when public speculation detaches from fundamentals, driven by greed, fear, and herd behavior, and notes that bubbles recur across centuries and asset classes. South Sea Bubble as the canonical case study (Priority: 5/5): The episode centers on the South Sea Company’s rise and collapse, including its debt-for-equity structure, political incentives, speculative frenzy, and eventual 90%+ drawdown. Sir Isaac Newton and the psychology of FOMO (Priority: 4/5): Newton’s trading in South Sea stock is used to illustrate how even brilliant people can be swept into bubbles, buy late, and suffer devastating losses. Trend following as a risk-management tool (Priority: 5/5): Faber describes a 10-month moving-average trend-following approach as a simple, rules-based way to sidestep major declines and improve risk-adjusted outcomes. Evidence across multiple historical bubbles (Priority: 5/5): Using 12 historical bubbles, the research compares buy-and-hold with trend following and finds better returns in most cases, plus consistently lower volatility and drawdowns. Behavioral importance of drawdowns (Priority: 4/5): The discussion emphasizes that investors care less about volatility in theory and far more about losses in practice, especially once drawdowns hit 10%, 20%, or worse.

Key Arguments: Bubbles are not rare anomalies; they have existed throughout financial history and are usually driven by human behavior rather than pure fundamentals. South Sea was a classic bubble because insiders, politicians, and the public all had incentives to keep prices rising despite weak underlying economics. A simple trend-following rule using a 10-month moving average can help investors exit collapsing markets before catastrophic losses deepen. Across 12 bubbles, trend following improved returns in nearly all cases and reduced volatility and drawdowns in all cases. The main benefit of trend following is not maximizing upside in raging bull markets, but preserving capital during crashes so investors can remain in the game. Drawdown reduction is more important than nominal return improvement because large losses trigger panic, forced selling, and permanent behavioral damage. Even highly intelligent investors, like Newton, can fail to resist the crowd once a bubble becomes socially reinforced and emotionally compelling.

Data Points: Historical bubbles analyzed: 12 - Cross-asset sample used to test trend following versus buy-and-hold Average nominal return during bubble periods: 3.5% - Across the 12 historical bubbles before accounting for the effect of crashes Average volatility during bubble periods: 22% per year - Higher than typical stock volatility, reflecting instability during manias Typical maximum drawdown: Around two-thirds - Average peak-to-trough loss across the bubble set Return improvement from timing model: Over 2 percentage points per year nominal - Summary result across the 12 bubbles Volatility reduction from timing model: About one-third - Compared with buy-and-hold across the bubble sample Drawdown reduction from timing model: Almost half, about 40% - Trend following reduced losses materially across the bubble sample S&P return, 1990 onward buy-and-hold: About 7% per year - Illustrative example including dot-com and housing-era market stress S&P return, 1990 onward with timing: About 10% per year - Illustrative example showing timing can sometimes outperform in addition to lowering risk S&P volatility, buy-and-hold: About 14% - Illustrative risk level for the sample period S&P volatility, timing model: Near 10% - Illustrative reduction in volatility from trend following South Sea stock peak: Nearly 1,000 pounds - Approximate top before the crash South Sea stock starting price: Around 100 pounds - Early level before the run-up South Sea stock collapse: Back to 100 pounds - Complete round trip after the bubble burst South Sea investor drawdown: Around 90% - Maximum loss described for late entrants like Newton Newton’s reported loss: 20,000 pounds - Catherine Conduit reportedly said Newton lost this amount Newton loss in modern terms: About 3 million pounds - Inflation-adjusted reference provided in the transcript Bubble Act date: June 9, 1720 - Law passed during the South Sea mania that restricted unauthorized joint-stock companies South Sea trend-following outcome: 44% loss/drawdown but overall large profit - Strategy still endured losses but preserved capital and finished strongly Potential wealth growth under trend following: Quadrupled money - Long-run result for the South Sea trend follower

Pivotal Quotes: "I can calculate the movement of the stars, but not the madness of men." — Sir Isaac Newton: Used to illustrate Newton’s inability to time or resist the South Sea bubble "surviving to invest another day" — Meb Faber: Core investing principle emphasized as the main value of drawdown control "What if Sir Isaac Newton had been a trend follower?" — Meb Faber: Central framing question of the white paper and the episode

Implications: For investors, the message is to respect bubbles, avoid fighting crowd psychology with intuition alone, and use simple systematic rules to manage risk. Trend following may lag in euphoric markets, but it can materially improve survival through crashes.