The concept of market bubbles and how they come about is addressed in a recent report authored by Morgan Housel of Collaborative Fund.

In the report, Housel supports the following arguments:

• Bubbles are an “unavoidable feature in markets where investors with different goals compete on the same field.”
• Bubbles are more closely related to “shrinking time horizon” than to rising valuations.
• Investors can best protect themselves by “understanding and acting upon your own time horizon, accepting that other people’s goals are different than your own.”

Citing the research of Hyman Minsky, an economist who attempted to provide an understanding and explanation of the characteristics of financial crises, Housel explains the notion that “stability is destabilizing. A lack of recessions plants the seeds of the next recession.” He expands on the above points:

Bubbles, says Housel, are not “so much about valuations rising. That’s just a symptom of something else: Time horizons shrinking.” He argues that bubbles are more about investors “rationally moving toward short-term trading to capture momentum that had been feeding on itself” rather than an irrational approach to long-term investing.

The most dangerous outcome of bubbles, writes Housel, is if an investor believes that the resulting drop in assets prices is viewed as an indicator that “everything you thought you knew about long-term investing is wrong.”

His conclusion: “Realizing that the rise and fall of bubbles does not negate the effectiveness of diversified long-term investing is one of the most powerful understandings an investor can have.”