Investment bubbles have become a regular part of the landscape in recent years. For investors, that means that avoiding boom-and-bust cycles has become an essential survival skill.
Why so many bubbles?
The collapse of Japan's market in the early 1990s. Various emerging market crises later in that decade. The dot-com bust. The bursting of the real estate market bubble, followed by the financial crisis. More recently, speculative peaks and plunges in oil and gold prices.
Why does this keep happening? After all, we are in the information age -- shouldn't investors be better informed than ever before? Not really. They certainly have more information, but more is not always better. The Internet and the 24-hour news media often fan the flames of hype and help it spread.
Meanwhile, international investing allows capital from around the world to flow into hot areas, so bubbles are less contained within national borders. Finally, the low-interest-rate environment of recent years is a contributor. With bank rates near zero, and Treasury yields not much better, investors are desperate for alternatives. Desperation often leads to mistakes.
Government intervention: help or harm?
Speaking of low interest rates, they are an example of how government intervention may do more harm than good when it comes to managing boom-and-bust cycles. The Federal Reserve has responded to a crisis of excessive borrowing by lowering interest rates to encourage even more borrowing, and in the process has driven interest-starved investors into more speculative asset classes. Meanwhile, lawmakers actively encouraged subprime lending and the deregulation of banking.
To a large extent, the government is eager to keep the party going for the time being, which means helping to make some bubbles bigger.
Minimizing the impact
So -- bubbles are a recurring threat, and the government is not going to save you from them. What then do you do?
Here are five ways you can minimize the impact of bubbles.
- Don't mind missing the party. The music always sounds good, until the police raid the joint. If something feels wrong, don't join in just because it looks like everyone else is having fun.
- Focus on your objectives. Don't get sucked into playing someone else's game. If you focus on investing to meet your needs and circumstances, you will be less inclined to follow the crowd.
- Diversify. It is one of the most basic of investment principles, but one that people abandon too readily. If you spread your investments out sufficiently, you will minimize the impact of any one bubble bursting.
- Use a sell discipline. When you buy something, have a target price at which you plan to sell. That way, if you are fortunate to see your investment go up, you won't get drawn into holding on just because it seems to be getting more popular.
- Rebalance. This will help you execute tactics 3 and 4: As individual investments or asset classes rise, periodically trim them back to keep them in line with your planned mix. That way, a bubble won't inflate an investment to the point at which it has an oversized impact on your portfolio.
Speculative bubbles are so ubiquitous, and their reach so widespread, that it would be unrealistic to talk about avoiding bubbles altogether. However, with some disciplined investing, you can minimize the impact and avoid disastrous damage to your portfolio.
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