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How to Spot an Investment Bubble

Filed in 20s , Investing 101 , Real Estate 12 comments

Bubble burstsDid your investments get slammed because you bought at the top of the market only to curse them all the way down?

Were you feeling anxiety because you listened to friends talk about flipping condos for a quick profit and felt like you were going to be left out?  Did you feel like you had to rush in and do the same because everyone else was doing so?

If so, you probably fell victim to the boom and bust investing bug.

Now that the phrase “investment bubble” has weaved its way into the American lexicon almost as deep as baseball and homemade apple pie, we may as well get used to seeing them on a regular basis. So it would probably be a good idea for you to find a way to identify the next bubble, for whatever type of asset it may be, so you’re not buying at the high and subsequently hating yourself for ever being so gullible in the first place.

Tips to Avoid the Next Investment Bubble

  1. Prices skyrocket 50% or more in a very short time span. When everyone is rushing to buy in a short time period, those who own what you want to buy will always ratchet up the price.  If Investment XYZ has already increased in value by 50% in less than one year (e.g. the 2008 oil bubble), how much further do you think it can realistically go before speculators begin to cash in their profits once the bubble has burst?
  2. Fundamentals no longer apply. If you can’t figure out why traditional research no longer applies to Investment XYZ, then why should you take the risk of buying it? This is often referred to as momentum investing where speculators chase the fast money, only to quickly liquidate their positions. It can be a profitable strategy, but better left to the pros or those who have the time to quickly liquidate their positions.
  3. Mainstream media mentions it on a very regular basis. Why mention other stories or do a little investigative journalism when one sector of the market moves 10% in a week. How many major media stories can you recall during early to mid 2008 other than the oil bubble?
  4. Everyone you know is following the market on a daily basis. I often find it hilarious that when the financial news can’t get any worse, most people tune out and ignore the doom & gloom message simply because they don’t want to hear it any longer. However, when the news is positive and stock arrows are green across the board, everyone wants to be an expert and buy stocks without ever really giving a solid reason why, except that everyone else is doing and they don’t want to be left out (e.g. fear of not making money often trumps fear of losing money).
  5. People laugh at you when you suggest it’s a bubble. Once an established trend is in place, most people are under the false assumption that the trend will never change. Some will even ridicule you for suggesting otherwise. Just ask anyone who bought a home from a Realtor who said that real estate will never — ever — go down in value.
  6. Dozens of books are published telling you how to get rich quick. The quick money experts will always surface right about the time the bubble is about to pop. Think back to all the “get rich on flipping properties” experts selling their programs on late night infomercials.
  7. The chart looks like a roller coaster ride from hell. If the value of Investment XYZ is up 50% one year, up 40% the next, then down 80% the following year, you are witnessing a bubble like investing trend. Everyone buys when the confidence is high, and dumps it the moment that confidence is lost. The first thing you should do prior to making any investment is to look at Investment XYZ’s historical prices (e.g. San Francisco real estate).

If you have any other suggestions, please be sure to share them below.
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Posted by CJ   @   23 July 2009 12 comments
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12 Comments

Comments
Jul 24, 2009
12:38 pm

Or as I like to say, “If people tell you it’s a sure thing, it’s not.”

Jul 26, 2009
7:49 pm
#2 Matt Jabs :

I especially like point 5. This concept seems to hold true if you are in any minority… regardless of topic.

Paving the way almost always results in ridicule… ironic isn’t it?

Jul 27, 2009
1:54 pm
#3 Matt :

@ MattJabs

Absolutely! I look back at my old post on “index funds are bad investments” and laugh when I see the black sheep picture.

What most didn’t see was that I wasn’t slamming the basic principle of an index fund (especially since I own them myself), but merely trying to shine a greater investigative light on what’s in them. The chain is only as strong as its weakest link after all.

I particularly enjoyed being called “irresponsible” or “having faulty logic” for making the call. Oh well, that’s my only Peter Schiff wannabe moment — thus far! ;-)

Jul 27, 2009
12:15 pm
#4 Bret :

Point 5 hits home for me.

A couple of years ago, an RE agent friend of mine approched me to invest in some senior housing units. When I told her it was a bad time and I expected housing to drop by 30-40%, she looked at me like I was from Mars.

Now, if only I could have predicted the stock market bubble a year later. Then, I could write a book or something.

Jul 27, 2009
2:35 pm
#5 Matt :

@ Bret

Thanks for commenting. I had a similar incident with a Realtor, but mine involved a Realtor advising me NOT to sell. When I sold my investment property in 2005, my Realtor told me I was out of my mind and gave me projections of a home purchased in 2001 doubling by 2007, tripling by 2009, etc.

Funny how potential profits acts like a drug, and poisons common sense thought. You could almost see his eyes glaze over with $$ signs.

Never mind that the property had increased in value by 50% in only 4 years, but as I told him, it was merely an investment and I want my profits while I had them.

May 4, 2011
11:48 am
#6 Geopulse Inc. :

Point no. 5 is really very much true. It is investment psychology that compels us to do like that…

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