Bubbles & busts

In the realm of economics, a bubble refers to a period in which current prices of an asset greatly exceed the fundamental value of the asset. Prices are inflated and purchasers are willing to pay or are paying very high premiums. A bubble can be formed around a single stock or the entire stock market, a financial asset or asset class and can even be formed around the entire financial market. Over time, the price of these assets begins to diverge upward from their true value and may not easily be noticed until the “bubble” has already been created.

The danger for investors in a bubble is its inconsistency. The unpredictability of when a bubble will begin, how long it will last and when will it end. These uncertainties make it hard for an investor to determine the best entry and exit points for investing in certain assets. At the onset, speculation begins to drive demand which then causes price increases. As speculation demand increases, prices are driven even higher above the true intrinsic value of the asset and the bubble gets bigger.

Investors in an asset class who have long owned an asset and are seeing price appreciation are happy and comfortable holding the asset for the foreseeable future. Onlookers seeing the price increase in the early stages will want to invest in the asset class as they perceive even greater price movement which can be profitable to them. As more persons begin to speculate on how much more the prices can appreciate, more entrants to the market will increase demand and prices will continue to increase.

There will be a period of euphoria as the high prices are pleasing to those currently invested. Gains/profits (even though unrealized) look good on paper and keep the investor confident in the investment decision. However, having investors who have invested at different price points and have different investment objectives can affect this period of euphoria. Early investors may decide that they can now sell and realize this previously unrealized profit. This can now be the start of the bubble bursting. As more persons begin to take profits, demand declines and prices begin to retract. Investors who invested mainly on speculation, may then become panicked as their unrealized gains begin to reduce and this can ignite a massive sell-off of the asset. The panic selling will cause prices to fall dramatically and result in a crash.

When investing, understand the intrinsic value of the asset to determine the price which you should pay. Make an informed decision and not one based on your own speculation or the speculation of others. Do not buy in just because everyone else is doing it or others have already profited from buying. Remember that in the case of a bubble, there were sellers at the heights of the bubble which means there were also buyers. Someone will be left holding an asset which they overpaid for and are now unable to sell and recoup their investment. Consequently, they are forced to hold indefinitely or to sell at a loss.

Always consult a licensed financial advisor when making investment decisions.

 Dwayne Neil, MBA, is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm Feedback: if you wish to have Sterling address your investment questions in upcoming articles, e-mail us at info@sterlingasset.net.jm.