Executive Summary
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We review the typical anatomy of financial market bubbles and subsequent crashes.
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We show that financial innovation has often triggered exuberant market developments, leading to unjustified market optimism and catastrophic losses for many investors.
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We emphasize the role that psychology and behavioral biases play in market dynamics before, during, and after a crash.
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We provide tips on how to navigate volatile markets more effectively in the inevitable bubbles and crashes of the future—inevitable because of the very nature of investor psychology and financial markets.
A Brief History of Bubbles and Crashes
For many, the tech bubble of the late 1990s is probably the most prominent example of a stock market boom and bust. Figure 1 shows the exuberance in the Nasdaq Composite stock market index, which includes a significant proportion of technology and telecommunications stocks, compared to the S&P500 Index of the 500 large-cap stocks from traditional sectors like industrials, transportation, utilities, and financials. As the internet and information technology spread throughout society, investors became ever more optimistic about the growth prospects and profit potential of companies involved in IT.
But irrational exuberance, as former Fed Chairman Alan Greenspan called it, is not a phenomenon of the information age. It has taken hold of financial markets time and again throughout history. Table 1 summarizes a selection of stock market slumps after periods of irrational exuberance in the United Kingdom and the United States since 1800. Two observations stand out: Bubbles and crashes are not rare, reoccurring at intervals of 10 to 30 years, and the subsequent market declines typically eliminate from 15% to 50% of the peak market value. Assets such as commodities, sovereign bonds, and currencies have also frequently shown signs of irrational euphoria followed by a severe correction.
Table 1. Selected UK and US stock market booms and busts since 1800. (Source: M. Bordo, 2003, UBS Wealth Management Research, as of July 25, 2008)
| UK boom and bust events | |||
| Boom (stock market increase, %) | Correction | Decline from peak (%) | |
| Latin America mania | 1822–1824 (+78%) | 1824–1826 | –37.3% |
| American boom | n.a. | 1835–1839 | –23.4% |
| Railroad boom | 1840–1844 (+52%) | 1844–1847 | –34.1% |
| European financial crisis | n.a. | 1874–1878 | –31.0% |
| Roaring twenties | 1920–1928 (+137%) | 1928–1931 | –60.3% |
| Housing boom | 1931–1936 (+110%) | 1936–1940 | –50.1% |
| Go-go years | 1965–1968 (+67%) | 1968–1970 | –18.9% |
| Tech boom | 1994–2000 (+89%) | 2000–2002 | –24.8% |
| US boom and bust events | |||
| Boom (stock market increase, %) | Correction | Decline from peak (%) | |
| Railroad boom | n.a. | 1853–1859 | –50.6% |
| Railroad boom | 1875–1881 (+51%) | 1881–1885 | –26.7% |
| Rich man’s panic | 1899–1902 (+30%) | 1902–1904 | –16.3% |
| World financial crisis | 1903–1906 (+52%) | 1906–1907 | –19.4% |
| Roaring twenties | 1920–1929 (+168%) | 1929–1932 | –73.4% |
| Post-war slump | 1941–1945 (+90%) | 1946–1949 | –10.8% |
| Go-go years | 1965–1968 (+31%) | 1968–1970 | –15.7% |
| Tech boom | 1994–2000 (+130%) | 2000–2002 | –27.7% |
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