Takeaway:
- Bubbles form when the underlying asset’s prices increase significantly above its intrinsic value, usually due to irrational factors.
- Diversifying your portfolio and doing deep research when making bets are ways to protect against bubbles.
- Housing bubbles have preceded recessions historically. There may be a housing bubble forming today. Stay cautious.
What are bubbles?
In finance, a bubble (aka asset, economic, or financial bubble) is when an asset’s price appreciates artificially and reaches levels well above its intrinsic value. Bubbles typically see prices increase due to irrational, emotional reasons unrelated to the underlying asset.
Any asset can be in a bubble. We are generally more worried about bubbles that directly impact the assets used to build and generate wealth. For example, the stock market and housing bubbles could result in significant losses for all stakeholders (average California home prices declined 42% from peak to trough over the Great Recession).
Because of how wide-reaching the stock and housing markets are (from investors who invested in them to employees who work in public companies and the housing sector), these bubbles could cause crises if they burst.
Protection from bubbles
Diversification is one way to protect against the devastating impact of bubbles. A well-diversified portfolio that is regularly rebalanced helps minimize risk and maximize potential.
“Never invest in a business you cannot understand.”
Warren Buffett
When and if you choose to invest in specific assets, whether it’s a stock, cryptocurrency, or physical asset, it’s essential to do your diligence to develop a data-backed and well-researched view of that asset’s intrinsic value.
Housing bubbles are particularly worrisome
There are talks of a housing bubble emerging in the U.S.
Here’s a scary fact. Since World War II, nine of the eleven recessions were preceded by a downturn in the housing sector (1).
The housing sector touches all parts of everyday life and represents a meaningful level of many individuals’ financial well-being. When a housing bubble bursts, discretionary income and savings change drastically for many people, resulting in tightened wallets. This sudden shift in spending behavior and financial outlook has ripple effects across other parts of the economy. This ultimately could lead to a recession.
As always, it’s important to be cautious and focus on an asset’s fundamentals.
Disclaimer: The contents of this website are opinions and are for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.