Three key drivers of investment bubbles

By: Tim Bennett

Bitcoin and cannabis both illustrate how investment bubbles can form. Tim Bennett explains why and looks at the implications for investors.

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Three key drivers of investment bubbles

Investment bubbles are often easiest to spot in hindsight once they have burst. So here I take a look back at Bitcoin and ask whether there are any lessons for investors tempted into the fast growing area of cannabis stocks.

The basic problem

No lesser an economist than John Maynard Keynes recognised the dangerous trait in our psyches that leaves us open to buying into a bubble;

In short, we are often not as good as we should be at taking the long-term view and avoiding what looks like an exciting opportunity to make a quick buck. So, how do we spot when an asset is heading for bubble territory?

The three ingredients

In order to inflate properly, investment bubbles need certain inputs;
We will take each in turn, using two recent examples to illustrate the potential risks, Bitcoin and cannabis.

A compelling story

Both of these relatively new asset categories, which on the face of it are very different, share a similar back story. As the next slide suggests, to build momentum behind a new investment you need a game-changing event (the financial crisis in the case of Bitcoin and legalisation in the case of Cannabis). It also helps in the current climate if you can fire the public imagination by, for example, positioning your offering as something that “the establishment” either can’t see the potential for, or is unable to easily access. Both Bitcoin and cannabis fit the bill;

Limited supply

The next key ingredient needed to whet investor’s appetites is the idea that there is a limited window of opportunity during which the really big gains will be made by those willing to act quickly. With Bitcoin you have always had the idea that only a finite number can ever be mined. With cannabis, the issue is a lack of publicly tradeable stocks, at least in the short-term.

A willingness to invest

The third ingredient is a little less tangible – you need a backdrop of a desire to take some risk. With interest rates so low for so long, for example, investors have been casting around for opportunities to generate higher returns. Layer in the fact that a 10-year bull market in stocks has floated all boats (to paraphrase US investor Warren Buffett) and you have the right backdrop against which to pitch a new investment opportunity.

The dangers

The history of investment bubbles suggests that a few people make a lot of money but that many others make none, or lose a lot. So, what are the key risks? Whilst there are certainly some good opportunities for investors in the cannabis space, there are some important caveats that make the correct stock selection crucial. First off, the number of ways of accessing this nascent market may increase and take away the limited supply argument as it does so. Next, there is huge regulatory uncertainty in the US – Canada may have legalised the drug but other jurisdictions may not follow suit. This makes estimating the eventual size of the market globally pretty tricky. Thirdly, over-the-counter (OTC) stocks of the sort currently available are often harder to analyse than their more mainstream peers due to a lack of information. It’s therefore a market where buyers need to do lots of homework.

The lesson?

Despite their obvious appeal in terms of a story, ordinary (i.e. non-expert) investors need to tread carefully when it comes to backing any new idea in its early stages. My advice would always be;
In other words, by all means speculate with money you can afford to lose if curiosity gets the better of you and you will suffer “fear of missing out” when it comes to an exciting new opportunity. However, don’t be drawn in too easily by the hype or be too easily impressed by rapid “paper” gains as a bubble inflates.