Bubbles Through Time
Bubbles have been part of the investment landscape since the early 1600s. The recent real estate and commodity bubbles are just the latest incarnations of the phenomena.
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Throughout history, there have been clearly
defined times in which investors ignore
available information, such as intrinsic
value or acceptable levels of risk, and
make — or hold — investments they might otherwise
avoid. Such times are often referred to as market “bubbles.”
In a bubble, asset prices are driven beyond what
many consider rational, only to come crashing back to
earth when the reality of intrinsic value — or a reverse
in investor sentiment — takes precedence. The current
economic crisis, triggered by the recent housing bubble
and related increase in subprime mortgage defaults, is
an example of an extreme bubble bursting.
Market bubbles are hardly new; countries throughout
history and around the world have seen them grow and
crash, from the Dutch tulip craze of 1637 to the recent
collapse of real estate prices in the United States. As an
investor, the question isn’t whether there’s going to be
another market bubble. Instead, what’s important is the
ability to recognize a bubble when it’s growing, avoid
making decisions that run contrary to your long-term plan
and position your portfolio to minimize the damage when
prices come back to earth.
Be Alert to Hype
In his 2001 paper, “Bubbles, Human Judgment, and
Expert Opinion,” Yale University professor of economics
Robert J. Shiller says that bubbles, by their very
nature, are the result of human behavior as much as
anything else, and that every bubble is likely to have a
definite shelf-life. “The essence of a speculative bubble
is a sort of feedback, from price increases, to increased
investor enthusiasm, to increased demand, and hence
further price increases,” he says. “The high demand for
[an] asset is generated by the public memory of high
past returns, and the optimism those high returns generate
for the future.” This feedback, Shiller argues,
encourages the market to reach higher levels than it
would if it were responding only directly to fundamental
forces. Once the cycle stops feeding on itself, a collapse
can occur, often with devastating effects.
So what can you do to make sure you don’t get
caught up in a bubble? “Investors can protect themselves
from bubbles by staying true to a long-term investment
plan. Stubborn adherence to a long-term plan will
often require both emotional and financial discipline, but
this fortitude is also usually rewarded when the bubble
du jour inevitably pops,” says John Skjervem, chief investment
officer for Northern Trust’s Personal Financial Services division.
In addition to maintaining a long-term focus and a well-diversified
portfolio, pay attention to the key indicators that a
market bubble may be developing — phrases and words like “the
new paradigm” or “modern” valuation metrics are often a good
clue. Similarly, if historical valuation gauges such as capitalization
ratios or price/earnings ratios are off the board, bubble hype
could be driving prices beyond the norm.
The Value of Fundamental Analysis
Human nature, and our natural inclinations to follow a crowd and
back a winner, can sometimes put you at odds with the fundamentals-based approach your
investment advisor likely follows.
Although markets contain a host
of additional factors that can move
an asset’s price up or down, the
key drivers of fundamental analysis
— measures such as appraised
value, sales, earnings, industry
strength and market share — can go a long way toward determining
an asset’s fair value beyond investor sentiment.
Not all increases in asset prices indicate a bubble, of course. “A
dramatic and extended rise in the price of an asset or group of
assets can be based on economics, if the factors for a change in
fundamental value are present and not just assumed,” says Dr.
Walt J. Woerheide, vice president of academic affairs and the
Frank M. Engle Distinguished Chair in Economic Security
Research at The American College in Bryn Mawr, Pa. “There are
cases where it looked like bubbles, but it turned out it was just a
major re-evaluation going on,” he says. Such cases include the
recent jump in the price of commodities, such as oil, which are
driven more by factors of supply and demand and less on pure speculation.
What’s important, he notes, is the ability to apply
these fundamental factors to determine if future expectations for
an asset’s performance are reasonable.
Bubblewrap Your Portfolio
Market bubbles have been a part of investing for nearly as
long as there have been investors. Fortunately, you can take
steps to protect your portfolio from the worst effects of the
Create a long-term plan and stick with it. Working
with an investment advisor to create an investment plan that
is focused on helping you achieve your long-term goals is a
good idea under any circumstances. Continuing to take a
disciplined approach to investing and adhering to your
plan when a bubble is swelling in the market can minimize
the effects when the bubble inevitably bursts.
Follow the fundamentals. When everyone is excited
about an investment’s potential, it’s natural to want to follow
the crowd. But reviewing the fundamentals underlying any
investment can help you determine if the people’s performance
expectations are realistic. Your investment
advisor can help you with this analysis.
Diversify broadly. While diversification isn’t a
guarantee against loss, having your portfolio spread
among a variety of different asset classes, industries
and geographic locations can help reduce the effects
of a popping bubble.
Rebalance regularly. Even the most carefully invested
portfolio can become unbalanced over time as different
asset classes perform better or worse than others. For this
reason, it’s important to work with your advisor to regularly
rebalance your investments so that no asset class becomes
over- or under-represented in your portfolio.
Diversify Broadly, Rebalance Regularly
Despite all of the warnings, bubbles do exist and in the market
corrections that inevitably follow their bursting, even savvy
investors can feel the effects. And, just like on the front end of a
bubble when the desire to get in on the action can be overwhelming,
the after-effects of a bubble can easily lead to a hurried
panic for the exits.
“There is a lot of similarity between bubbles and panics.
They’re very much the same phenomenon, just in opposite
directions,” Woerheide says. “In a panic, people think they see
incredible disaster, and they start selling like crazy. So whoever
is buying at the bottom can become extremely wealthy when
those prices bounce back and people realize how oversold
stocks have become. In bubbles, it’s sort of the same thing,
only the guy that gets hurt the most is the one that buys at the
top.” To that point, Skjervem adds, “Condo-flipping recently
ended every bit as badly as day-trading did at the end of the
last cycle, another reminder that investors are ultimately best
served by a long-term investment plan that includes well
designed allocations to multiple asset classes.”
For many investors, such a plan is likely to include two
key components: diversification and regular rebalancing.
Although diversification can not guarantee against loss, by
diversifying your portfolio by asset class, investment style,
geographic location and industry, you stand the best chance
of reducing a bubble’s impact. Similarly, by rebalancing — or
working to make sure that no asset class is over- or under-represented
in your portfolio — the effects of a bubble in any
one class may be minimized.
A Rational Response
For his part, Shiller acknowledges that there are market participants
and observers who shrug off the concerns of more prudent
investors whenever a bubble is either on the horizon or
has already arrived.
In writing about the then-recent bubble in technology stocks,
Shiller noted that “[some] sharply disagree with these bubble
stories, and it ... seems to them that the high valuations the market
has placed on the stock market can be attributed to actions
of rational investors who are wrestling with hard-to-interpret evidence.
[For these investors], suggesting that investors at large
have been irrational seems arrogant and presumptuous.”
But whether some investors think others are irrational or not,
what’s clear is that bubbles are likely to be a part of the landscape
for a long time. Financial markets are volatile by nature,
and there will always be investors seeking outsized gains. The
combination of the two has led to bubbles in the past, and will
do so again in the future. Recognizing a bubble for what it is
and taking the necessary steps to reduce its impact will go a
long way in making one more endurable.