How to avoid being caught in an investment bubble

- March 22, 2022 3 MIN READ
Investment bubble

They are the investment phenomenon which makes a person’s wildest financial dreams come true and then instantly shatters them. Investment bubbles have been inflating and bursting for hundreds of years.

The wild ride of the gold price and the value of Bitcoin over the last few years is a timely reminder that while asset price bubbles can be fun on the ride up, you don’t want to be caught in the inevitable bust.

The key is identifying when your investment is becoming a bubble, rather than just delivering strong asset value growth. It can be a fine line and investment bubble identification is often done in hindsight. But we have plenty of history to draw on for guidance.

Historic investment bubble trouble

Many of us are old enough to remember the gold bubble of the late 70s and early 80s, when the precious metal dropped a whopping $300 overnight on Valentine’s Day 1980.

Since then there’s been the Japanese “Take Over The World” bubble in the 1980s; the Asian Currency bubble of the mid 90s; the Dotcom bubble of the late 90s; and the Global Easy Credit and US Housing Bubble of last decade which culminated in the Global Financial Crisis.

You’d think all investors by now would have had the concept of investment bubble risk seared into the decision-making part of their brain. Those who didn’t get caught in the Dotcom meltdown almost certainly lost a few layers of skin in the GFC that followed.

But it seems even painful crashes haven’t stopped buyers from driving other assets into bubble land, where prices are higher than good old-fashioned investment fundamentals like supply and demand dictate they should be.

What have we learned from previous bubbles?

Remember when the sharemarket value of dotcom darling Ecorp eclipsed the market value of Woolworths, even though it had a fraction of the sales revenue and was still making massive losses?

Inevitably the investment cheer leaders in bubbles such as this start using language like “traditional investment fundamentals don’t apply in this case because….” or “it’s different this time because….” or “there’s no limits because we’re changing the paradigm by…”. 

Whenever you start hearing this type of language you should start to be concerned. Investment history tells us every investment runs in a cycle and they generally gravitate back to their historic average if the pendulum swings too far to either the up or the downside.

Many investment experts say we’re even more susceptible to a new investment bubble today than ever before. And that these bubbles are inflating and deflating quicker. The reason is technology and investment products like Exchange Traded Funds

This combination means larger amounts of money can swamp an investment quickly to push up values rapidly. But they can then be pulled out just as quickly, which causes a rapid burst of the bubble. Pop.

Between the crossroads of technology, new investment products and general fanfare, some say cryptocurrency was destined to be an investment bubble from the very beginning…

Are ETFs driving cryptocurrency back to record high prices?

What’s the best investing strategy?

The investor strategy seems pretty simple. See a bubble, walk away. 

The problem is it’s all but impossible to spot a bubble before it collapses. Even experts seldom agree about whether a given investment fits the bill. One analyst’s catastrophe-in-the-making is another’s new traditional opportunity.

To help you avoid an investment bubble, here are some of the tell-tale bubble scenarios I’ve come across over the years which sound a warning:

  1. A believable process or technology which offers a revolutionary and unlimited path to growth. This was the foundation of the Dotcom bubble.
  2. Excess cash and lack of opportunities lead to buying or investing in anything available. Often the basis of housing booms.
  3. An idea is complex and cannot be totally explained or related to an investor. Remember Firepower and its “pill” to drop into the petrol tank for better efficiency? For me, crypto also falls into this category.
  4. The lemming phenomenon where the crowd imitates the leader. Even the gardener has a tip? The Nickel/Poseidon boom of the 70s is basically replicated in some shape or another every 5-6 years on the sharemarket. 
  5. New fundamental levels are sanctioned by supposed experts claiming “We are in a new Paradigm!” 
  6. Financial institutions relax their lending practices. Easy money flows like water to anything or anyone with a new idea. 
  7. Cult figures emerge for the new paradigm. The media promotes the “greed is good” gurus and lauds over their lifestyles. Beware of the current crop of ‘finfluencers’…
  8. Everyone has a reason why it cannot continue. But nobody sells, and all hold onto their profits. No new buyers. Market stalls.