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This is one of my favorite investing books.

In this article, I interviewed author Didier Sornette.

Then, I discussed the parts of the book that have been most applicable for me as an investor.

Critical Events In Complex Financial Systems

This note is one of a series about the books that have informed and inspired my life and work. Click here for the previous book, Tomorrow's Gold.

Conversation with Didier Sornette on Why Stock Markets Crash

What has changed since your book?

I have deepened greatly my understanding of the reason for bubbles in the last 30 years and developed a macro-view of where we come from and where we are going, with important implications for investments.

What investment insights does Sornette offer?

Our economy has become ever more financialized in the past three decades in an unsustainable illusion of a perpetual money machine. The corollary is that true and sustainable value is more likely to be found in sectors have with the potential for real growth of production through new technologies, innovations and creativity such as biotechnology and healthcare.

What was most applicable?

This book laid out how financial bubbles and crashes have nearly identical major characteristics, despite spanning centuries and continents. These characteristics emerge long before the market crash:

  1. The initial, smooth phase of the bubble begins with inflating demand in an optimistic market environment.
  2. Secondly, interest in investments with growth potential draws increasing amounts of capital. Unlike classic models, these are highly dependent, not independent, variables. New capital typically uses leverage, comes from novel sources, and includes foreign investors. This round of new capital drives prices higher.
  3. Less sophisticated investors and increasing amounts of leverage are drawn in. Extreme use of margin accounts causes the demand for securities to outstrip the pace that real money enters a market.
  4. By this point, the market behavior becomes weakly coupled from real wealth production from the industrial and service sectors.
  5. Prices skyrocket. The quantity of remaining investors available to enter the speculative market begins to dwindle. Without new entrants, the market becomes volatile. As soon as the instability becomes clear, the market collapses. Typically these collapses equal the entire amount of asset price inflation from steps 1-4.

These phases, as described in detail in the book, held true during the tulip bubble of 1636 in Amsterdam, in the U.S. stock market in October 1929, and even in the housing finance bubble and crash in the years following the book's publication.

An important part of the mechanics of bubbles and crashes appears to be the overuse of buying on margin. Increasing use of margin accounts make it difficult to slow markets in an orderly fashion. While this book is not about public policy, it occurs to me that statutorily limited use of margin by financial institutions could be an effective core of financial regulation. Strict collateral requirements could interrupt the process of bubbles and crashes.

Publisher's Description

The scientific study of complex systems has transformed a wide range of disciplines in recent years, enabling researchers in both the natural and social sciences to model and predict phenomena as diverse as earthquakes, global warming, demographic patterns, financial crises, and the failure of materials. In this book, Didier Sornette boldly applies his varied experience in these areas to propose a simple, powerful, and general theory of how, why, and when stock markets crash…

Any investor or investment professional who seeks a genuine understanding of looming financial disasters should read this book. Physicists, geologists, biologists, economists, and others will welcome Why Stock Markets Crash as a highly original "scientific tale," as Sornette aptly puts it, of the exciting and sometimes fearsome--but no longer quite so unfathomable--world of stock markets.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.