What Are Bubbles?

I keep hearing about bubbles. There was the tech bubble in the late 1990s, the oil bubble, housing bubble, debt bubble. Why do they keep happening and how can I avoid losing money in them? – R.A., Minnesota

April 19, 2010 - Answered by Gordon T

Gordon T's Answer:

Financial bubbles have always been part of investing. Here are a few more bubbles for your list: the South Sea Bubble in 1720, the British Railway Bubble in the 1840s, the Florida Real Estate Bubble in 1926, and far too many more to list.

A financial bubble occurs when there is a rapid expansion of prices of an investment asset type, taking the price beyond a rational level, followed by a dramatic often rapid price decline. Anybody can make money when an investment is going up. The problem is getting out of the investment before the losses. Knowing when to get out is the trick.

Not every asset or investment that enjoys a rapid price appreciation is in a bubble. Price increases above the historic averages, and ahead of other current investment options, are common and sometimes justified. When is a rapid price increase a bubble, and when is it just a good investment? It isn’t easy to tell the difference until it is too late. Bubbles are only obvious when we look back at them.

In the early stage of a bubble, conversations typically turn to how a person’s house has doubled in value or how their particular stock portfolio has soared. It can be a warning sign that a bubble is forming when the returns on some type of investment become a common topic of ordinary conversation.

Economists debate the causes for bubbles. Each one has its own origins. Housing prices began their sharp increase when lending standards were loosened and low interest rates resulted in loans to poorly qualified borrowers. The dot-com bubble began when new technology led to the widespread use of the Internet, igniting a search for ways to profit from it. The South Sea Bubble began after a single company was granted a monopoly to trade in Spain's South American colonies.

Bubbles grow when investors rely on recent past performance to make investing decisions. Numerous studies confirm that past performance is a poor predictor of future performance, yet investors continue to act otherwise. The average investor will too often buy an asset after, and because, its price has risen, and then sell after the price falls: buy high—sell low.

It seems inevitable that other bubbles will occur, and may be occurring now. Will gold continue to rise? Are oil prices unsustainably high or will they go higher? Will the dollar lose value against other currencies? All these and more are potential bubbles today, but any or all may turn out to be good investment choices.

What can you do to avoid being hurt by investment bubbles? Unfortunately, some bubbles have broad consequences, hurting even those who did not participate directly, such as when the recent housing and debt bubbles led to a serious recession. Here are a few tips that might help:

  • Select your portfolio with an eye to risk as well as return. That means not making investment decisions based only on recent past performance. Risk is always a part of any investment. Investments that have had a recent dramatic price increase should be considered more risky than before they surged.
  • Question any investment fad no matter how fabulous it seems to be at the moment.
  • Diversify. Learn about the various categories of investments (primarily stocks, bonds, and cash equivalents) and the holdings within each and spread your investments across them, based on your personal goals and investing time horizon.
  • Be skeptical of advice from anyone who will collect a commission if you buy and do not listen too trustingly to the experts. They often turn out to be wrong.
  • Never invest in anything that you do not understand; read investment disclosure documents, ask questions, and if you don’t get understandable answers, do not buy.

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