Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers — for a time — expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.

Bubbles aren’t so much about valuations rising. That’s just a symptom of something else: time horizons shrinking as more short-term traders enter the playing field.

The formation of bubbles isn’t so much about people irrationally participating in long-term investing. They’re about people somewhat rationally moving toward short-term trading to capture momentum that had been feeding on itself.

Prices driven up by the expectation that they would go up, the expectation realized by the resulting purchases. Then the inevitable reversal of these expectations because of some seemingly damaging event or development or perhaps merely because the supply of intellectually vulnerable buyers was exhausted.

In bubbles, infatuation with market momentum takes over from any notion of value and fair price, and greed (plus the pain of standing by as others make seemingly easy money) neutralises any prudence that might otherwise hold sway.

"First, price changes are not independent of each other. Research over the past few decades, by me and then by others, shows that many financial price series have a "memory," of sorts. Today does, in fact, influence tomorrow. If prices take a big leap up or down now, there is a measurably greater likelihood that they will move just as violently the next day. It is not a well-behaved, predictable pattern of the kind economists prefer-not, say, the periodic up-and-down procession from boom to bust with which textbooks trace the standard business cycle. Examples of such simple patterns, periodic correlations between prices past and present, have long been observed in markets-in, say, the seasonal fluctuations of wheat futures prices as the harvest matures, or the daily and weekly trends of foreign exchange volume as the trading day moves across the globe."

Even a relatively mild inflation distorts the structure of production. It leads to the overexpansion of some industries at the expense of others. This involves a misapplication and waste of capital. When the inflation collapses, or is brought to a halt, the misdirected capital investment — whether in the form of machines, factories or office buildings — cannot yield an adequate return and loses the greater part of its value.

Out of that belief, thus instilled, then comes action — the bidding up of values, whether in land, securities, or, as recently, art. The upward movement confirms the commitment to personal and group wisdom. And so on to the moment of mass disillusion and the crash. This last, it will now be sufficiently evident, never comes gently. It is always accompanied by a desperate and largely unsuccessful effort to get out.

And the reason people get screwed is that by the time they hear that the stock market (or gold, or the real estate market, or commodities, or any other type of investment) is a great place to go, very often the bubble is just about to end. So you need to put in place a system to make sure you don’t get seduced into putting too much of your money in any one market or asset class or too much in your Risk/Growth Bucket.

"The most-studied evidence, by the greatest number of economists, concerns what is called short-term dependence. This refers to the way price levels or price changes at one moment can influence those shortly afterwards-an hour, a day, or a few years, depending on what you consider "short." A "momentum" effect is at work, some economists theorize: Once a stock price starts climbing, the odds are slightly in favor of it continuing to climb for a while longer. For instance, in 1991 Campbell Harvey of Duke- he of the CFO study mentioned earlier-studied stock exchanges in sixteen of the world's largest economies. He found that if an index fell in one month, it had slightly greater odds of falling again in the next moth, or, if it had risen, greater odds of continuing to rise. Indeed, the data show, the sharper the move in the first, the more likely is is that the price trend will continue into the next month, although at a slower rate. Several other studies have found similar short-term trending in stock prices. When major news about a company hits the wires, the stock will react promptly-but it may keep on moving for the next few days as the news spreads, analysts study it, and more investors start to act upon it."

Ray then revealed the most simple and important distinction of all. There are only four things that move the price of assets: 1. inflation, 2. deflation, 3. rising economic growth, and 4. declining economic growth.

Markets go up. Markets go down. We always make money.... Get used to it

"In science, all important ideas need names and stories to fix them in the memory. It occurred to me that the market's first wild trait, abrupt change or discontinuity, is prefigured in the Bible tale of Noah. As Genesis relates, in Noah's six hundredth year God ordered the Great Flood to purify a wicked world. Then "were all the fountains of the great deep broken up, and the windows of heaven were opened." Noah survived, of course: He prepared against the coming flood by building a ship strong enough to withstand it. The flood came and went-catastrophic, but transient. Market crashes are like that. The 29.2 percent collapse of October 19, 1987, arrived without warning or convincing reason; and at the time, it seemed like the end of the financial world. Smaller squalls strike more often, with more localized effect. In fact, a hierarchy of turbulence, a pattern that scales up and down with time, governs this bad financial weather. At times, even a great bank or brokerage house can seem like a little boat in a big storm."

"My current best model of how a market works is fractional Brownian motion of multifractal time. It has been called the Multifractal Model of Asset Returns. The basic ideas are similar to the cartoon versions above-though far more intricate, mathematically. The cartoon of Brownian motion gets replaced by an equation that a computer can calculate. The trading-time process is expressed by another mathematical function, called f(\propto), that can be tuned to fit a wide range of market behavior. My model redistributes time. It compresses it in some places, stretches it out in others. The result appears very wild, very random. The two functions, of time and Brownian motion, work together in what mathematicians call a compound manner: Price is a function of trading time, which in turn is a function of clock time. Again, the two steps in the model combine to produce a "baby" far different from either parent."