Beginner's guide to investing part 5: Bubbles, crowd madness & opportunities

In part five of the beginner's guide to investing, I look at how investors can be smart by picking a buying opportunity and benefitting from the madness of crowds and investment bubbles so that they can choose the right moment to buy shares.

Article updated: 30 October 2020 12:00pm Author: Michael Baxter

When is a good time to buy shares? This question is important. Choosing the right moment to buy shares can make the difference between an enormously successful investment and a plodding investment that offers okay returns. The key can lie with patience and waiting for the buying opportunity.

In part three of the beginners guide to investing, I talked about diversifying over time. The idea is to mitigate against bad luck. Predicting a market crash is tricky. If you have a lump sum and you invest it all on the same day, you take the risk that the markets may crash soon after and it may take several years before you are back in profit. But if you drip feed your money, say over three or four years you reduce this risk quite significantly.

But you can be smarter than that. You can choose your moment. 

Examples of buying opportunities

Let's take some examples. After the dotcom crash at the beginning of this century, the FTSE 100 lost almost half of its value. But if you had bought into the index in early 2003, you would have gone close to doubling your money within four years.

Something similar happened after 2008, and maybe we saw a repeat this year with the Covid crisis.

But you can be cleverer still. The dotcom crash especially hit technology stocks. But if you had bought into Apple 12 months after the crash and held, then right now you would have increased the value of your shares 300 times. It would have been a similar story with Amazon. You might respond that this is being wise in hindsight, but if you had invested $1000 in one hundred tech companies 12 months after the crash, and 98 subsequently went bust. However, two of those companies were Apple and Amazon; then you would have still have increased the value of your investment six-fold.

So, by maintaining diversification but picking your moment to buy, you could see exceptional performance.

Markets are not rational that's why we get bubbles 

And why is this possible? The markets are not rational. The markets constitute the aggregation of buying and selling by individuals. But these individuals are influenced by what others are doing. The reason for this is simple: the mood is contagious. This is why we get madness of crowds. This is why financial history is replete with tales of bubbles, from the Dutch Tulip Bubble of the early 17th century, the Mississippi bubble and South Sea bubble of the early 18th century, the railroad bubble of the 19th century, the broader bubble which led to the 1929 crash, the dotcom bubble at the turn of the millennium and the subprime bubble that preceded the 2008 crisis.

Often these bubbles catch out the wise. Issac Newton lost a fortune from the South Sea bubble. He said afterwards: "I can calculate the motion of heavenly bodies but not the madness of people." Almost 300 years later, the IMF said that thanks to the innovation of mortgage securitisation the risk of a banking crisis had reduced.

Now I am not saying you can second guess a bursting bubble — but I am saying that in the aftermath of a burst bubble, buying opportunities emerge and they emerge because the markets exaggerate. When the mood is right, shares rise and markets become almost euphoric. After the crash, the markets don't seem to be able to see good in anything.

Buy when all around is gloom, sell when all around is euphoric

There is a saying that sums it up pretty well: "sell when all but the most bearish of investors has turned bullish, and buy when all but the most bullish of investors has turned bearish.

Let me give two anecdotes to illustrate how this works, but in the case of the first anecdote the lesson relates to selling.

The first story goes that Joseph Kennedy, the father of the assassinated president, sold his shares in 1929 before the crash, after a shoe shine boy had asked for his advice on what stocks to buy. Kennedy reasoned that everyone was looking at buying shares, that the world had gone bullish, so he sold.

The second relates to Lord Rothschild. I am not sure what date this relates to. When I first heard this story, it was applied to the French Revolution of 1848, subsequently I read it applied to the more famous revolution of 1789. The story goes that Lord Rothschild said it was time to buy. But his trusty servant replied: "But the streets of Paris are covered in blood, to which the Lord is said to have replied: "Buy when there's blood on the streets, even if the blood is your own."

The sage of Omaha

Warren Buffett, possibly the most successful investor of all time, also has advice on the best time to buy. He likens the approach to a batter in baseball, awaiting the ideal pitch. Buffett says: "If he waited for the pitch that was really in his sweet spot, he would bat .400." "If he had to swing at something on the lower corner, he would probably bat .235."

He continued: "The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, 'Swing, you bum!,' ignore them.

"You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

I think this approach is as natural as you can get: see a parallel with nature: the tiger or leopard, patiently waiting the optimal moment to strike.

Keynes, the investor

But I will leave you with one other investing guru.

The economist Keynes was also an enormously successful investor, but he lost a fortune at one point and was partially bailed out by his father. He said: "the markets can remain irrational longer than you can remain solvent."

Keynes also said: "As time goes on, I get more and more convinced that the right investment method is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence… One's knowledge and experience are definitely limited, and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence."

Now those words could easily have been spoken by Buffett. It is a very similar ethos. But combine the approach Keynes described here with patience, waiting for the right moment, then the results could be outstanding. 

Are you new to investing? This is one part of a series; catch up with the other parts here:

Beginners guide to investing in shares

Beginner’s guide to investing part 2: risk, volatility and why invest?

Beginner’s guide to investing part 3: five tips for investing

Beginner's guide to investing part 4: know the product

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

See what else we have to say