Warren Buffett believes it takes three I's to create a bubble. Innovators, imitators, and idiots. "Everyone goes along and you look kind of silly if you disagree."
It takes a lot of courage and conviction to go against the majority. I usually use Internet trading, and it can be difficult to click my mouse sometimes "to buy" because everyone else is selling. However, my best stock picks have been contrarian. I'm a little scared when everyone agrees with me on a particular stock. On the other hand, I feel more secure when everyone is depressed. I believe it is human nature to follow the herd. When your neighbor is making money from real estate or stocks, you feel like a fool if you're not involved. But, the last buyer always loses money.
George Soros believes that a bubble occurs when everyone believes a particular asset class cannot go down in value.
Bubbles are a part of life. There was a stock market bubble before The Great Depression. Most people can remember the Internet bubble of the 1990s. Now we're dealing with the aftershocks of a real estate bubble. There was also a mini-bubble in Chinese stocks over the last few years.
Joseph Kennedy, father of John F. Kennedy, famously sold all of his stocks after a shoeshine boy gave him stock tips. He figured at that point, everyone was invested in the stock market, and there was nowhere to go but down. Kennedy was able to save his money and invest in real estate during The Great Depression. In 1929, he had $4 million. By 1935, his wealth increased to $180 million.
I've noticed similiar trends with individual stocks. When the p/e (PER), price to sales, market capitalization, and price to cash flow ratios start getting insane. It's time to bail out. Warren Buffett sold his shares of PetroChina for around $160-$170 per share. Today, PetroChina trades at $97 per share. Just buy stocks and hold onto them forever? I don't think so.
(If you're curious, Buffett paid about $21 per share for PetroChina.)
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