Avoiding an investment bubble is not as easy as it may seem. If it were, investors would take appropriate steps and the bubble would never be created in the first place.
So what can you do to avoid losing a lot of money quickly? Let us consider some common sense avoidance tips.
Understand the Life of a Bubble
In “Investment Bubbles“, we looked at the five distinct stages of a bubble. If you invest during the Displacement or Euphoria stages and get out before Revulsion sets in, you can prosper. If you wait too long to invest or divest, you will be in trouble.
It is the ability to properly identify each stage that takes skill and experience. That will hopefully come in time for most of you. When I say skill, not simply technical skills. You will need common sense and intuition to identify trends and behavioural patterns in investors and the public. For the most part, no calculators required.
If you are interested in learning to spot investment bubbles, please review my post “Learning to Spot an Investment Bubble.”
Never Get Greedy
An old investment proverb states, “Bulls make money, bears make money, but pigs get slaughtered.”
A bull is an optimist who believes that the share price will rise. A bear is a pessimist who believes that the share price will fall. A pig is simply someone that is greedy. Many investors are pigs.
Some experts consider a short-term increase in share price of 50% as an indication of a bubble. But I hate putting absolute values on relative terms. However, if there is a sharp price increase be wary of a potential problem. Whether that is 25%, 50%, or 100% depends on many other factors outside this discussion.
If the price rises quickly and/or significantly, take some profit. Better to sell a few months early at a profit, than to wait even a day too late. You may find yourself caught in the Revulsion phase and lose everything when the bubble bursts and the share price collapses.
Do not be a pig. Avoid getting slaughtered.
For Every Buyer, There Must be a Seller
And vice-versa. To sell your shares, you must find a buyer. And that person believes the share price will continue to rise (why else would they buy the shares?). As the share price climbs, each day there will be fewer investors who believe the stock will continue to increase and the less people who will want to buy your shares.
Basic supply and demand. If there are less buyers wanting your shares, the premium they will pay you falls. At some point, there will be more sellers than buyers in the marketplace and the share price will start to fall.
As the price begins to drop, more selling will occur and the shares will fall farther and faster. The remaining shareholders will stampede for the exits and the bubble will break, sending the share price crashing down. With no one buying, this can occur very quickly and steeply.
If you want to enjoy your earnings, leave a little share upside for the next person. Sell when the stock is still in the Mania phase of the bubble, when there is still strong demand for the shares. As you gain experience, you can extend the selling into the Distress phase. Remember though that the selling has begun and Distress may rapidly give way to Revulsion.
Let someone else try and time the market and sell at the last possible moment. You will have better long term success exiting early and not trying to hold the shares until the very last second. Plus, you will avoid getting an ulcer.
Do Not Simply be an Investment Expert
“Get your facts first, and then you can distort them as much as you please.” Mark Twain.
Numbers can be massaged to fit almost any purpose. Sometimes you just need to sit back and use your own common sense to make decisions.
In early 1999, Amazon had prior year revenues of $400 million and was operating at a net loss. Yet Amazon’s share price was $221 and, more importantly, its market capitalization was $35 billion. Barnes & Noble, Amazon’s primary rival, had annual sales of nearly $3 billion, yet their market capitalization was only about $3 billion. Barnes & Noble was worth 1/12 of Amazon, yet Barnes & Noble had 8 times the revenue.
You do not need a degree in finance to understand that the numbers made no sense. Yet many experts believed that Amazon, and other dot.com companies at that time, would continue to rise in price.
Being a financial expert definitely improves one’s investing skills. But you still need to use some common sense as well. Many experts forget this and get caught up in the hysteria of a market or stock. As a result, they let the facts mislead them.
Keep calm, use some common sense when assessing an investment, and you will have a better chance of long term success.