How to Spot and Avoid an Investment Bubble

via Perth Now and Business Insider

BUBBLES are the investment phenomenon which makes a person’s wildest financial dreams come true and then instantly shatters them.

Investment “bubbles” have been inflating and bursting for hundreds of years.

BubbleThe wild ride of the gold price and the value of digital currency group Bitcoin over the past few weeks is a timely reminder that while asset price bubbles can be fun on the ride up, you don’t want to be caught in the inevitable bust. The key is identifying when your investment is becoming a bubble rather than just delivering strong asset value growth. It can be a fine line and bubble identification is often done in hindsight. But we have plenty of bubble history to draw on for guidance.

We’re old enough to remember the gold bubble of the late 1970s and early ’80s, when the precious metal dropped $300 overnight on Valentine’s Day in 1980.

Since then there’s been the Japanese ‘Take Over The World’ bubble in the 1980s; the Asian Currency bubble of the mid ’90s; the Dot Com bubble of the late 90s; and the Global Easy Credit and Housing bubble of past decade which culminated in the global financial crisis. Those who didn’t get caught in the Dotcom meltdown almost certainly lost a few layers of skin in the GFC that followed.

But it seems even painful crashes haven’t stopped buyers from driving other assets into bubble land where prices are higher than good old fashioned investment fundamentals like supply and demand dictate they should be.

Remember when the sharemarket value of dotcom darling Ecorp eclipsed the market value of Woolworths, even though it had a fraction of the sales revenue and was still making massive losses?

Inevitably, the investment cheerleaders in bubbles such as this start using language such as ‘traditional investment fundamentals don’t apply in this case because … ‘ or ‘it’s different this time because … ‘

Whenever you start hearing this type of language, you should be concerned.

History tells us every investment runs in a cycle and they generally gravitate back to their historic average if the pendulum swings too far to either the up or the downside.

Many investment experts say we’re even more susceptible to new investment bubbles today than ever before.

The reason is technology and new investment products such as exchange-traded funds.

This combination means larger amounts of money can swamp an investment quickly to push up values rapidly but can then be pulled out just as quickly to cause a rapid burst of the bubble.

The investor strategy seems pretty simple: See a bubble, walk away.

The problem is it’s all but impossible to spot a bubble before it collapses, and experts seldom agree about whether a given investment fits the bill.

One analyst’s catastrophe-in-the-making is another’s new traditional opportunity.

Warning Signs

So to avoid being caught in an investment bubble, here are some of the warning signs:

1. A believable process or technology which offers a revolutionary and unlimited path to growth. This was the foundation of the Dotcom bubble.

2. Excess cash and lack of opportunities lead to investing in anything available. Often the basis of our housing booms.

3. An idea is complex and cannot be totally explained or related to an investor. Remember Firepower and its ‘pill’ to drop into the petrol tank for better efficiency.

4. Follow the leader. The Nickel/Poseidon boom of the ’70s that seems to be replicated in some form every five to six years on the sharemarket.

5. New fundamental levels are sanctioned by supposed experts claiming ‘We are in a new paradigm!’ Yeah, right!

6. Financial institutions relax their lending practices. Easy money flows like water to anyone with a new idea.

7. Cult figures emerge for the new paradigm. The media promotes the ‘Greed is good’ gurus and praises their lifestyles. 8. Everyone has a reason why it can’t continue. But nobody sells. There’s no new buyers and the market stalls.

You know you are in a bubble when the G20 expresses concerns about the consequences of ultra loose policy for too long. A Forbes survey shows money managers to be at their most bullish over the past 20 years. Gold coins are all the rage from India to Germany (why?). CFTC positioning confirms this view of extended risk taking (long commo and usd vs mainly jpy), while equity ETF flows shows that the US has been the clear darling vs the rest of the world and this for a while. In parlance discouraged by the Economist Style Guide, we are on Hopium squared.

The cost of not participating is too high as performance falls vs peers or benchmark.

Why do bubbles accelerate when identified? The cost of not participating is too high as performance falls vs peers or benchmark.

Timing the correction and its intensity is also much harder than participating, while I am sure a bunch of behavioral biases are at work (see James Montier books from GMO).

 

HOW TO AVOID INVESTMENT BUBBLES

  • Invest in quality assets.
  • Understand what the investment does.
  • Take profits on the way up and bank them.
  • Have a balanced approach to your portfolio.
  • Understand exactly where you are in the investment cycle.

 

 

 

George Dorgan
George Dorgan (penname) predicted the end of the EUR/CHF peg at the CFA Society and at many occasions on SeekingAlpha.com and on this blog. Several Swiss and international financial advisors support the site. These firms aim to deliver independent advice from the often misleading mainstream of banks and asset managers. George is FinTech entrepreneur, financial author and alternative economist. He speak seven languages fluently.
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