Investment strategies can be used to reduce the risk of getting caught in a bursting investment bubble. Here are a few practical strategies for consideration.
1. Diversify Your Investment Portfolio
Avoid investing too much money in any one stock or sector. Both in absolute dollars and as a percentage of your overall portfolio.
An entire market may experience a bubble. However, there is a greater probability of seeing a crash in an individual sector and an even greater likelihood in an individual stock.
By diversifying your assets you avoid having all your eggs in one basket. And suffering total loss if that basket slips and all your eggs break.
Diversification spreads out the risk of individual investments and reduces the overall risk of your portfolio. The more you diversify through time and asset class, the greater the risk reduction benefit for your portfolio.
Why this is true and how to practice diversification is important to understand. This concept will be examined in much greater detail at a slightly later date.
2. Play with House Money
Some investors sell their holdings piecemeal as the share price climbs. Or, if the share price doubles, they will sell half of their stake. Regardless of the mechanics employed, the plan is to sell enough over time to recoup the initial investment. In Las Vegas terms, they are now playing with the house’s (i.e. casino’s) money.
For example, you buy 5000 shares of ABC for $2 per share. Ignoring transaction costs and taxes, you invested $10,000. In 6 months the share price has risen to $4. You sell one half your holdings, 2500 shares, and net $10,000. The same amount you invested. You still own 2500 shares that did not really cost you a cent.
Whether the shares continue to rise or fall to nothing, you have recovered your initial investment. You are now playing entirely with “house money”.
By selling some shares early, you will not maximize the possible return. But do you think you can pick the optimal time to sell? It is not an easy thing to do.
By recovering your investment, you eliminate all risk of loss. You will never worry about waking up one day to read that ABC’s product was found to cause cancer in consumers and had fallen to $0.01.
Reduce your risk and do not be too greedy.
Remember, be a pig and you might just get slaughtered.
3. Dollar Cost Average and Rebalance
For young investors with a long-term investment horizon, this is a good method.
Dollar Cost Averaging
In short, dollar cost averaging means that you buy a fixed dollar amount each investment period.
You might invest $200 each month into a mutual fund. Or $100 each month into your brokerage account and buy Citigroup shares every 6 months.
The key is to consistently invest a specific dollar amount and not worry about the share price.
The advantage of dollar cost averaging is that you buy more shares when the price is low and less shares when the price is high. That provides some protection against short term price movements.
You do not try and time the market for your acquisitions. Find a strong, long term investment and buy over time. The greater the price, the less units you can buy.
For example, Matt plans to invest $360 quarterly in the ABC no-load equity fund. Quarter one, the fund trades at $10 per unit. Matt buys 36 units. Quarter two, the fund falls to $5 per unit, so Matt buys 72 units. Quarter three, the fund is at $8, so Matt buys 45 units. In quarter four, the fund has increased significantly to $15, so Matt is only able to purchase 24 units.
By year end, Matt has invested a total of $1440 ($360 each quarter) and owns 177 units. His average cost per unit is $8.14. The year end market value is $16 per unit, $2832 in total. Matt has done well.
Maybe Matt could have done better by properly timing the change in unit price over the year. But maybe he would have done worst. If everyone knew the correct times to buy and sell there would be many richer investors. At any rate, Matt has managed to avoid some stress by not trying to time purchases and sales.
This investment strategy is very useful for non-expert, passive (i.e. not actively choosing stocks and jumping in and out of the market) investors with a long term time frame. The type of investor that most of you currently are.
Unfortunately, dollar cost averaging alone will not keep you safe from bubbles.
You also need to rebalance.
Investors should create target asset allocations for their investment portfolios. How to arrive at one is unique to each individual, based on their personal circumstances and appetite for risk. This is a topic we shall discuss in the near future.
Let us assume Matt has a simple asset allocation formulation. 10% cash, 30% fixed income, 60% equities. To meet this target, each quarter Matt invests $600. $60 (10%) goes into a money market fund. $180 (30%) is invested into a bond fund. $360, as above, is invested into the ABC equity fund.
Matt invested according to his target asset allocation. However, Matt finds the following during his year end review. With interest, his money market fund is valued at $242. The bond fund has increased 3% and is now $742. The equity fund has performed well and is worth $2832 at year end.
Matt’s portfolio actual asset allocation is now 6.34% cash, 19.44% fixed income, and 74.2% equities. To get back to his target, Matt must sell some of his equity fund and invest the proceeds into cash and fixed income. In this example, he needs to sell 34 units at $16 per unit and put an extra $140 in cash and $404 into the bond fund.
The new year begins back at the target allocation and the process of investing, reviewing, and rebalancing commences again.
Psychologically, it is always hard to sell investments that have grown in value. But rebalancing periodically is a good way to protect against a crash.
I suggest portfolios be reviewed quarterly to semi-annually and rebalanced semi-annually to annually. As transaction costs and taxes play a significant role in reducing portfolio returns, do not adjust too often and create extra costs for yourself.
As I believe that dollar cost averaging and rebalancing is an excellent investment strategy for young adults, we will discuss this more deeply in the future.
4. Option Strategies
There are a variety of strategies utilizing derivatives that can be used to safeguard against investment bubbles. However, at this stage of the game, let’s leave these until (much) later for contemplation.
Practice these strategies and you will reduce the chance of being caught in an investment bubble.
As always, the best of success in your investing.