Avoiding the Bubbles: Knowing when Not to Buy Can Save You Thousands

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One of my goals here at SF is to discuss sound personal investing.

Not exactly a novel concept I know, and I’m sure you can find a myriad of columnists and self promoting TV personalities screaming BUY! BUY! BUY! as loudly as possible just to get your attention.

I’m really not that sort of investor or blogger.

I’m more of the type to say when you should avoid a particular investment. If everyone rushes in, it will obviously cause current market prices to spike abnormally high from historical trends, and that’s where I would like to think I can give SF readers a moment of pause before signing on the dotted line or clicking the BUY button.

Case in point, a school bus driver who bought a $800,000 home nearing foreclosure proceedings. This home has lost $125,000 (~16%) from the purchase price, the family almost certainly bought at the peak of the real estate bubble, and they be lucky to fully recover from this financial setback if the home enters foreclosure proceedings.

Knowing How to Spot a Bubble

Spotting an economic related bubble isn’t difficult. Whether it’s a bubble in the real estate market, a stock market bubble, or an individual commodity like gold, they are basically caused by similar factors and are rather easy to spot.

Simply take a look at historical prices, and look for a huge spike in market value. If current prices have suddenly spiked abnormally higher from past values, then it could be a good time to sit on the sidelines, and wait for prices to become more reasonable.

For example, consider the housing crash of the late 2000s. The chart below (click for larger view) is an illustration of just how severe the real estate bubble actually was compared to historical home prices dating as far back as 1890.

It doesn’t take a genius to spot the surge in prices. If you bought at the top of the 2006 peak, you’re likely on the losing end of your home purchase and underwater on your mortgage. Of course, if you still have the capacity to pay your mortgage there really isn’t a substantial problem unless you’re interested in selling the property soon.

Point being, if someone is out there screaming BUY as loud as they can, they might have a vested interest in getting you to purchase whatever it is there selling. A Realtor or a mortgage broker maybe?

Combine that with the peer pressure of wanting to follow along with the herd and buy along side everyone else is a pretty substantial reason to jump in without using the proper judgment. Keep fighting off the urge, and you’ll almost certainly find that in a few years, prices will come down and those same people who called you a moron for sitting on the sidelines will likely have lost tens of thousands of dollars.

Or better yet, giving you a chance to be a vulture investor and buy their assets at half price.

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Posted by Matt SF @ 26 February 2009 10 comments

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Feb 27, 2009
10:00 am

#1 Julia :

Are there bubbles that you see emerging now? It seems like gold has been increasing past historical norms, but I’m a total novice at this kind of thing.

[Reply]

Feb 27, 2009
11:06 am

#2 Matt :

@ Julia,

I think a bubble in gold is a definite possibility. It’s a “fear” trade only since gold generates no income on it’s own and it becomes a hot item in times of uncertainty.

The most obvious bubble that I see are in US Treasuries, which you can see in it’s tracking ETF symbol TLT. Scroll out to the 1 year chart.

I’ve also been concerned that the S&P 500 is in a bubble. If you look at the 50 year charts, it becomes a bit concerning to say the least. I’m not saying it exists, but if we keep challenging the lows we’re eventually going to head back to lows of the mid 90s.

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