Bubble, Bubble, Toil and Trouble?

Some see economic bubbles boiling up everywhere: the real estate bubble, the current tech bubble (the one in the late ‘90s went pop!), and even new bubble “currencies” like Bitcoin are raising concerns.

Is this Bubble Trouble? That’s hard to say.

Bubbles happen in almost every economy and they’re nearly impossible to predict in advance. But when they burst, they can have big economic repercussions. That’s all the more reason to understand bubbles and how to potentially protect your portfolio from their impact.

What are bubbles?
Market bubbles develop when people notice the fast rise in the value of an investment (such as a stock). In hopes of profiting from further increases, investors buy more and more even though the price is much greater than the investment’s actual value.

Once people realize the investment is priced much more than it’s worth, the bubble pops. That’s when the price of the investment plummets, and many investors lose much (if not all) of their initial investment.

Overall, bubbles are a natural part of the economic cycle and they’ve been around for centuries. Take the Holland tulip bubble of the 1600s, for instance.

In 1636 – 1637, the price of certain varieties of tulip bulbs rose incredibly fast. Before long, people were trading their life savings to buy more tulip bulbs. Prices rose higher and higher until, at the height of the bubble, a person could trade a single tulip bulb for an entire estate.

Once the bubble burst, that same bulb would only fetch the price of a common onion. Virtually all citizens of Holland suffered, if not from the loss of their life savings, then from the resulting economic crash.

It may seem outrageous that such a financial craze could happen over a mere tulip bulb. However, you never know what will start a bubble — or what will cause it to crash.

We might snicker at those dopy Dutch. But take the dot-com bubble of the ’90s. In 1995, the excitement over the fast-developing technology and the so-called “new economy” grew to a frenzy. Investors were more interested in the next big idea than in evaluating business plans.

On March 10, 2000, the Nasdaq Composite peaked at 5,046.86. Just 10 days later, the Nasdaq had fallen by 10 percent. And by 2001, the bubble was deflating at full speed. After using up their venture capital, many startups went under, having never made a profit.

Can you protect your portfolio?
Predicting the next market bubble is next to impossible. However, you can consider taking steps which may protect your portfolio from its impact:

  • Diversify. Keep your portfolio diversified among different asset classes and even different investment approaches (for example, exposure to commodities, natural resources, or hedged strategies are now offered to retail investors through products like mutual funds).
  • Focus on the long term. Avoid making large investments in the latest “big thing.” Instead, stick with your investment plan and focus on the long term.
  • Keep your monthly expenses low. When the bubble bursts and the economy falters (or crashes), you don’t want to be stuck with high monthly expenses like credit card debt, a ballooning mortgage, or big car payments. Keep your costs low during the good times so you’ll be prepared for the bad times.
  • Know your risk tolerance. If you just can’t stomach the thought of a 30 percent drop in your investments, make sure your portfolio allocation reflects that, and stay away from high-risk investment options.

Get professional advice
Not sure if your portfolio is ready for the next bubble? A financial professional can help you create a balanced portfolio that reflects your goals and your tolerance for risk.

 

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal® are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Asset allocation/diversification does not guarantee a profit or protect against a loss.

Long/short investing does not guarantee lower risk associated with equity markets, capitalization, sector swings, or other factors and may have higher turnover with additional tax consequences. Short selling risks include investment loss and added costs to cover short positions. Investments in natural resource industries can be affected by disease, embargoes, international/political/economic developments, variations in the commodities markets/weather, and other factors. Investing in derivatives entails specific risks regarding liquidity, leverage, and credit that may reduce returns and/or increase volatility. Use of alternative strategies may magnify risk. Securities such as bonds, equities, international and emerging market securities, and currencies are subject to risks associated with market and interest rate movements.

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