The “housing bubble” caused all sorts of chaos in our financial system over the last few years. People tend to attribute it to villainous bankers, and incompetent president, a senile Fed Chairman, or whatever bogeyman they most like to assign blame to. When it comes down to it, though, it was a product of runaway human emotion and ambition; frighteningly simple and intuitive. In this post we will look at the basics of what a bubble is.
[Note: This post is a broad explanation. If you want more specific information and data about the housing bubble, see this post.]
A bubble is most commonly created by irrational exuberance on the part of a large / powerful portion of the population trying to “not miss out.” You might hear people refer to the concept of the “band wagon” in many aspects of life. A bubble occurs because people jump on an investment band wagon. Even when a rational investor should know that the assets are severely overvalued, the market continues to rise based on the sheer volume of people who want “in.”
What’s the lesson here? Strangely, it’s often the guy in situation B in the above illustration that makes the most money. You don’t make money off of a bubble by thinking it will stop at a rational level. The timing, though, is mostly luck, as no one knows when the bubble will pop. If you ride a bubble, be proactive on your exit strategy. All it takes is a little bit of downward movement for everyone to realize at the same time how crazy their actions have been.
In any case, we love to talk about “speculators” as nameless, faceless villains, but in fact the speculators in the housing market were all those around us; the people who bought houses with the idea that they couldn’t lose. Flipping houses, owning multiple houses, and continually changing houses to realize profits were the speculative actions that drove the bubble. Everybody wanted in on a phenomenon that didn’t have a rational basis. Unfortunately, the less sophisticated investors who didn’t recognize that a bubble was underway were the ones who mostly got left hanging, with houses worth a fraction of what they had paid for them. The end of a bubble is brutal; a quick and cruel “pop.”
It isn’t hard to see how the housing bubble occurred given how easy it was for people to buy and sell houses. It’s just human nature to try to capitalize on “free money.” There still, however, remains the question of how this all started. How did that band wagon get rolling? Unfortunately, it did so with the best of intentions, which I’ll get to soon in another post.