In the second half of his year-end letter, GMO’s Jeremy Grantham takes a look at numerous asset bubbles throughout history, warning investors to ignore bubbles at their own peril.

“Responding to the ebbs and flows of major cycles and saving your big bets for the outlying extremes is, in my opinion, easily the best way for a large pool of money to add value and reduce risk,” Grantham writes. “In comparison, waiting on the railroad tracks as the ‘Bubble Express’ comes barreling toward you is a very painful way to show your disdain for macro concepts and a blind devotion to your central skill of stock picking. The really major bubbles will wash away big slices of even the best Graham and Dodd portfolios.”

Grantham says that bubbles form because of a cycle in which investment managers, feeling the career risk in making bold moves, fall prey to “herding”. It also involves what he calls “double counting”. Profit margins, he says, are mean-reverting, meaning that at times when margins are high, investors should be willing to pay less per dollar of earnings. In reality, what often happens, he says, is that when margins are high, inflating earnings, investors pay more for each dollar of earnings.

“It is a classic fallacy of composition,” he says. “For an individual company, having an exceptional profit margin deserves a premium P/E against its competitors. But for the market as a whole, for which profit margins are beautifully mean reverting, it is exactly the reverse. This apparent paradox seems to fool the market persistently.”

Also necessary for a bubble to form: a generous money supply, Grantham adds.

Grantham also shows how bubbles — from the South Sea Stock Bubble of the early 1700s to the recent U.S. housing bubble — always go back to their original trend that was in place before the bubble formed.

To download a full copy of Grantham’s report, visit GMO’s web site. (Free registration is required.)