Market Bubble? Reminders for Investors
~ By Herb White, MBA, CFP ~
In the world of investments, people who understand the nature of bubbles and busts and heed the warning signs ultimately fare better than those who throw caution to the wind, preferring to trust what is ultimately just luck. One of the truisms about the markets is that every bubble will eventually lead to a bust. Timing them is impossible, but heeding some warning signs and principles is key. Let’s take a look.
Characteristics of bubbles
Bubbles and busts are cyclical, that is, occurring regularly and periodically.
Bubbles are characterized by surges in asset prices to levels significantly above the fundamental value of that asset.
Bubbles ultimately are followed by a bust. Investors can be prepared to weather these cycles using a little caution mixed in with some market smarts.
Another way to view these cycles is described by Yale University economist Robert Shiller: a bubble is “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person
despite doubts about the real value of an investment.”
Look at History for Evidence
Consider one of the most infamous occasions when a long-running bubble eventually turned into a bust. In the late 1990s, a significant bubble involving many technology stocks occurred. Yet many investors ignored warnings about a bust and continued to buy strongly into the tech markets. They were said to be exhibiting “irrational exuberance” during this tech bubble, characterized by the Nasdaq growing more than 200% over three years. Not recognizing or understanding how bubbles behave, or perhaps throwing caution to the wind, many investors’ losses were significant when the bust occurred. As Alan Greenspan, previous chairman of the Federal Reserve, had predicted, prices plummeted, although the bubble lasted for three years after he put out the warning.
This is a good example of why history is a great teacher. Although market bubbles and busts cannot be timed, caution is called for. Keep an eye on the companies’ fundamentals, such as sales, earning, financial strength and future prospects. If these are out of alignment with prices, caution is advised and examination of the situation is in order. Talk to a financial professional to help you put the situation into proper perspective.
Are we in a bubble today?
Today’s financial environment is a good example. All indications are that we likely are in a bubble or one is inevitable. Being armed with information and a good dose of caution this time will help investors make wise decisions about how they should proceed.
When might the next bust occur? It is guesswork, but keeping a close eye on the markets is recommended. Remember that when valuations, measured by P/E ratios, rise significantly, above their long-term averages, this is the time to be concerned about a bust. Whether you are a large or small investor, the need to understand the signs is so important to this process.
“This time it’s different!”
This is a frequently heard comment from analysts who rationalize that we couldn’t be in a bubble because many indicators are nowhere near peaks of the late 1990s. But comparing one situation with another isn’t prudent. Investors should use caution when they hear hype like this and remember that every bubble is different.
If you are a long-term investor, remind yourself that any sharp increase in prices is generally not sustainable over the long haul. Continue with the financial and retirement plans you have made and have been following, and do not be led into taking the wrong tact with your investments. Talk to your financial advisor for further guidance on this important issue.
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Provided by courtesy of Herb White, MBA, CFP©, a CERTIFIED FINANCIAL PLANNER™ 8400 E Prentice Ave, #715 Greenwood Village, Colorado, www.lifecertain.com, (303) 793-3999. Securities and investment advisory services offered through Woodbury Financial Services, Inc. Member FINRA, SIPC and Registered Investment Advisor. Insurance offered through Life Certain Wealth Strategies. Life Certain Wealth Strategies and Woodbury Financial Services are not affiliated entities.