We hear a lot about investment bubbles, mainly due to the fact that when a bubble pops, those left holding the asset find themselves with something practically worthless.
An investment that is in a bubble seems like a good idea right up until the price crashes. But how do you tell an investment that is simply seeing some well-deserved growth from one that is in a bubble? There are four signs that can help you recognize that an investment is probably in a bubble:
1. Skyrocketing Price
One of the major signs that an investment is headed into bubble territory is a skyrocketing price. The price might be shooting up quickly, seeing rapid appreciation. There doesn’t seem to be any cap on the price; it just keeps going higher.
A skyrocketing price doesn’t always have to be something that happens in a short period of time. Sometimes, as in the case of the housing bubble in the United States, it can take years for the bubble to burst. In other cases, an investment bubble can grow and burst in a matter of weeks or months.
2. A Great Deal of Hype Surrounds the Investment
While not every hyped investment is in a bubble, an investment that is surrounded by a lot of hype could very well be in a bubble. Everyone talked about buying a home, insisting that prices would rise, and that everyone should have a home. “It’s an investment that always appreciates” was a regular selling point.
Other assets see similar effects. If you notice that a lot of people are talking about an investment, and pointing to its skyrocketing price, that could be a sign that the investment is in a bubble. It’s not exciting to talk about the progress of a venerable dividend aristocrat that grows slowly over time. No one gets hyped about that sort of investment. When you start hearing talk about the latest “it” investment—especially if it prompts your generally clueless co-worker to talk like he’s an investing genius—you could be looking at something that’s in a bubble.
3. Everyone Seems to Be Ignoring the Fundamentals
Is the only “newsworthy” thing about the investment its skyrocketing price? You might be in trouble. A focus almost entirely on the price action and little thought given to fundamentals could be the sign of a bubble.
The fundamentals, or the big picture items that support an investment, are very important if you are looking for long-term success. Savvy investors know that things like P/E ratios, profits (and profit margins), company management, political currents, and other factors affect an investment. It’s not a lot of fun to look at cash flow and debt, but it’s important. After awhile, the savvy investors look at an asset and realize the fundamentals don’t justify a bubbly price. They sell en masse, leaving the less savvy investors to deal with the effects of a burst bubble.
Look at the fundamentals of an investment before you decide to part with your money. If the fundamentals aren’t strong enough to warrant the huge climb in price, stay away. Don’t be dazzled by talk of instant riches because the price just keeps climbing.
4. This Time It’s Different
There was a time, just before the housing bubble burst, that some thought that we’d reached the end of true down cycles in real estate. “Housing is different,” was the refrain. This attitude prevails just before other bubbles burst as well. Somehow, proponents of the investment insist, there is something different about this investment, or there are special conditions that allow this asset to appreciate indefinitely.
It’s not different. Any asset that rises in price quickly is volatile enough that it could crash just as quickly. And, of course, you need to look at the fundamentals to see what could be coming. The housing bubble went on long enough that some thought the game had changed. However, there were voices of dissent looking at the fundamentals underpinning the real estate market, and realizing they weren’t sound. Any asset is subject to a bubble—even if it looks like it isn’t.
Before you get excited about the next hot investment, take a step back. Try to leave your emotions behind. Evaluate whether or not that asset is moving into bubble territory. If it looks like a bubble, stay away.
Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.