In my previous post I talked about the 5 stages of a stock market bubble and how to identify if one is occurring. In this post I’d like to discuss why stock market bubbles are likely unavoidable for the diversified investor and how to manage your exposure to collapsing prices.
Investing in stock market bubbles
Because asset prices experience strong growth during a stock market bubble, there is a huge potential to profit from such events. In addition to this if your portfolio is diversified, it’s likely that you will hold shares that are part of a market bubble.
Risks of stock market bubbles
Which companies/assets will survive?
During the boom phase more competitors start to move into the new investment space and new products are created. As the market moves into euphoria even more companies/assets within that class will emerge hoping to get a hold of the capital pouring into the market. A key risk here is that it is incredibly difficult to tell which companies will survive a market crash. Companies that are heavily indebted and have poor cash flows tend be the riskiest. During the Dotcom crash search engines like Altavista, and Yahoo lost significant market share to Google; and during the GFC Lehman brothers failed.
Greed, fear and overconfidence
Greed and fear are two key emotions that drive investment during a stock market bubble. When prices rise strongly for years, overconfidence takes over and gives investors the feeling that prices will not recede. Further to this, watching others make more money than oneself goes against human nature and drives purchasing based on the fear of missing out (FOMO).
The Australian property market is a classic example of overconfident investing, where growth that lasted for over 20 years caused sayings such as ‘safe as houses’ to become common place throughout Australian culture.
Devaluation of assets
If panic selling occurs, then assets will be devalued very quickly. As retail investors we are often unable process information quick enough to know when to get out without experiencing significant loss.
Risk of completely avoiding a stock market bubble
Warren Buffet has a saying that the market can be irrational longer than you can be solvent. So even if you are right, and a particular asset class is completely overvalued, there are times when prices will just keep rising. Despite the high level of focus on collapsing prices once a stock market bubble has burst, stock bubbles are not something to be avoided. In fact, one could argue that not being invested, and reaping the rewards, is as risky as losing money during panic selling. For example, in 1999 the NASDAQ rose more than 60%; imagine completely sitting on the sidelines during such a year. I’m not trying to encourage FOMO investing here but merely trying to illustrate that it is not wise to move everything to cash for fear of an asset price collapse.
What risk management tools are available to retail investors?
Diversification
Diversification reduces risk and volatility by limiting exposure to individual assets and or asset. classes. Using the Dotcom bubble as an example, gaining exposure to the growing tech sector by using a portfolio comprised of 30% NASDAQ and 70% S&P 500 indices an investor would have experienced losses, from peak to trough, of 66% instead of 77%.
The principle of diversification further extends to investing in individual stocks vs indices e.g., buying Amazon vs. buying the NASDAQ. More concentrated portfolios provide the possibility of even higher returns but are matched by the possibility of greater losses. The key lesson here is investing 100% of your portfolio into a single asset is a far riskier play than the vast majority of people can handle.
Dollar cost averaging
If you are investing in a diversified instrument such as an index fund then dollar cost averaging through the ups and downs provides excellent protection in falling markets. In the long run; many indices continue to grow, and surpass their previous highs. In the, case of the NASDAQ, it took about 15 years before the index passed its peak in 2000, however, continuing to apply dollar cost averaging over this time would have lowered your weighted average cost of capital, and increased overall returns.
Asset allocation
Asset allocation is where an investor chooses a set asset allocation based on their risk tolerance and adjusts their portfolio when it becomes misaligned. As an example, if an investor had a target asset allocation of 30% cash and 70% NASDAQ index at January 1st 1992 their $100,000 portfolio would be as follows:
| 1/1/1992 | |
| NASDAQ (70%) | $70,000 |
| Cash (30%) | $30,000 |
| Total Value | $100,000 |
Assuming the cash does not attract any interest and no additional funds are added or removed then on the 1/1/2000, their portfolio would look something like this:
| 1/1/2000 | Actual | Target |
| NASDAQ (70%) | $444,726 | $332,309 |
| Cash (30%) | $30,000 | $142,417 |
| Total Value | $747,726 | $747,726 |
To maintain their target asset allocation, they would then have to sell $112,418 of their NASDAQ holdings to bring it down to their target $332,309. This allows the investor to profit from a market that might be overheating without the trying to predict asset price movements. A secondary effect being that the other assets within the portfolio provide downside protection if, and when, the prices fall.
Use leverage with extreme caution
The use of leverage (debt) can make you rich if things go your way but, if they don’t, you’d better be able to deal with the consequences. Let’s say you’ve borrowed $1M to invest in a new web browser technology call Netscape Navigator, if its value goes up 3,000% and you’re only paying 6% to service the loan, congratulations, you’re a self-made rich guy that can buy a new mansion. However, if the company goes bankrupt, as many do during bubbles, you are now on the hook for $1M plus interest. Congratulations, you can still afford to buy new home but it’ll probably be a cardboard box under a bridge.
Given the same scenario, if you only lost your own savings on this investment, the impact would be far less severe. Sure, rebuilding wealth is a pain, but I’d much rather rebuild from $0 rather than -$1M. The key lesson here is that you should only take on as much leverage as you are able to service if things turn out poorly. This also extends to being able to hold on for as long as is required to make a profit, if you cannot afford to service the debt under rising repayment conditions then you’ve taken on too much. History tells us that during bubbles, many individual companies will become completely worthless and indices can lose 70%, or more of their value.
Personally, I would avoid leverage completely when investing in individual speculative assets as the risk of failure is far too high for my tolerance.
Acknowledge human nature
I talk a lot about human psychology on this blog because I believe that you can have all the computational tools in the world but still fail at personal finance if you cannot overcome your own psychology. For better or worse, greed is an integral part of human nature, and it is what drives many stock market bubbles into euphoria. Additionally, we are hard wired to compare ourselves (wealth especially) to others, which often generates the fear of missing out (FOMO). As an investor you need to acknowledge that both emotions are completely normal, and often can never be satisfied by making more money – there will always be someone richer and always someone that’s making better returns.
Stop trying to compete with others and instead focus on your own goals and financial planning. Acknowledge that everyone is at a different stage and has a different starting line in personal finance. For me, doing this comes with the realization that the returns that I need are dependent on my goals (which are unique to me); so, seeing other’s achieve higher returns doesn’t affect my investment decisions. This helps me to focus on the wealth building activities for the FFE house which is an infinitely more productive use of my time.
Timing is not a reliable risk management tool
While it seems obvious in hindsight, trying to pick the time when a bubble moves from euphoria to profit-taking is almost impossible. Even if you are certain that the market is going to crash, converting 100% of your holdings to cash too early will have a negative effect on your overall portfolio returns.
If indicators such as a large deviation from fundamentals cause you to believe that an asset you own is going to experience a severe and permanent drop in value aim to reduce exposure via incremental adjustments to your target asset allocation rather than selling everything at once. Alternatively, if your asset allocation is aligned with your risk tolerance, simply rebalance your portfolio to meet target. Remember that being certain that a correction is coming is very difficult and predicting when it will hit it’s peak is practically impossible, so rarely does drastic behavior yield the positive results.
Concluding thoughts
Stock market bubbles are events that are driven by overconfident speculation. For savvy investors that can adjust their portfolios accordingly they represent opportunities to materially increase wealth. However, it is important to recognize when valuations become disconnected from fundamentals as the risk of a correction increases materially during this time. If the market is experiencing euphoria, it would be wise to asset overall portfolio risk and suitably adjust your asset allocation. Further to this, you should exercise extreme caution when using debt to invest in speculative assets and focus on adjusting your portfolio to suit your own goals as opposed to comparing yourself with others.
Engineer your freedom
References
Yahoo finance, 2021, S&P 500 (^GSPC) Adj close 1/1/1992 to 1/12/2004 (Monthly), Yahoo finance, available from: <https://au.finance.yahoo.com/quote/%5EGSPC/history?period1=694224000&period2=1101945600&interval=1mo&filter=history&frequency=1mo&includeAdjustedClose=true>
Yahoo finance, 2021, NASDAQ Composite (^IXIC) Adj close 1/1/1992 to 1/12/2004 (Monthly), Yahoo finance, available from: <https://au.finance.yahoo.com/quote/%5EIXIC/history?period1=694224000&period2=1072915200&interval=1mo&filter=history&frequency=1mo&includeAdjustedClose=true>