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Why Bubbles get formed

Hat Tip: Niraj Bardia

Ask yourself: How much should you have paid for Yahoo! stock in 1999?

The answer depends on who “you” are.

If you have a 30-year time horizon, the smart price to pay was a sober analysis of Yahoo!’s discounted cash flows over the subsequent 30-years.

If you have a 10-year time horizon, it’s some analysis about the industry’s potential over the next decade and whether management could execute on its vision.

If you have a 1-year time horizon, it’s an analysis of current product sales cycles and whether we’ll have a bear market.

If you’re a daytrader, the smart price to pay is “who the hell cares?,” because you’re just trying to squeeze a few basis points out of whatever happens between now and lunchtime, which can be accomplished at any price.

When investors have different goals and time horizons — and they do in every asset class — prices that look ridiculous for one person make sense to another, because the factors worth paying attention to are totally different.

People can look at Yahoo! stock in 1999 and say “This is crazy! A zillion times revenue!

This valuation makes no sense!”

But many investors who owned Yahoo! stock in 1999 had time horizons so short that it made sense for them to pay a ridiculous price.

A daytrader could accomplish what they need whether Yahoo! was at $5 a share or $500 a share, as long as it moved in the right direction. Which it did, for years.

Money chases returns. Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term.

That process feeds on itself. As traders push up short-term returns, they attract more traders. Before long — and it really doesn’t take long — the dominant price-setters with the most authority are those with ever-shortening time horizons.

Bubbles aren’t so much about valuations rising. That’s just a symptom of something else: Time horizons shrinking. This might seem like subtle point, but it explains a lot about why the mere existence of bubbles confuses so many smart investors.

-from Collaborative Fund

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