Sometimes, being a smart investor involves knowing when to do nothing. When there’s way too much excitement about an investment opportunity, the hype may form a bubble that can cause financial damages when it bursts.
You might be able to protect your money by simply sitting things out, no matter how tempting it is to join in. Find out what bubbles are and how you can avoid them in this article.
What is a bubble?
A bubble refers to an event where the price of something—whether it's a single asset like a company’s stock or multiple assets tied to entire industries or markets—balloons and rises to an unsustainably high level.
This can happen when investors get caught up in the excitement of rising prices. They may start buying based on an expectation that prices will just continue going up, even if there’s no underlying factor that justifies the increase.
When the hype pushes prices way beyond an asset’s “real” value, the bubble eventually bursts. A price crash typically follows, leading to losses for those who bought in when prices were already too high.
Questions to ask yourself when identifying a bubble
Some people attempt to profit from bubbles by trying to sell right before they burst. This type of speculative trading can be very risky since it’s hard to predict when prices will hit their peak.
What makes prediction extra difficult is the fact that investors can become greedy when they are already sitting on gains. They might continue holding on to overpriced assets believing that their value will keep rising over the foreseeable future.
It may be better for you to steer clear of speculation if you’re investing to build wealth over the long term. You can do so by choosing assets whose prices reflect what they’re truly worth.
Know the signs of overinflated prices to avoid investment bubbles. Here are a few questions to ask before investing:
1. Are you influenced by biased thinking?
Think about why you’re interested in an investment opportunity. Is there an objectively good reason to invest, or are you just curious about skyrocketing prices and don’t want to miss out?
Bubbles are often fueled by behavioral biases, like herd mentality or the fear of missing out (FOMO).
When doing your research, beware of confirmation bias, or the tendency to only accept information that already aligns with your opinion. It can make you feel like you’ve done your due diligence when you’re not really looking at the whole picture.
Taking the time to look for trustworthy sources and considering all angles – even when they don’t align with your beliefs – can save you from a lot of trouble down the road.
2. Do the prices reflect real values?
Another red flag is when the price of an asset seems disconnected from its real value. One example is when a company’s stock price is soaring, but it’s not making much money or has a lot of debt.
This could indicate that the stock is overvalued, meaning the price is too high compared to what the company is actually worth. Checking a company’s fundamentals is a good way to gauge its long-term value.
If you’ve looked at the fundamentals and can’t find a strong reason why an asset is priced the way it is, there might be a bubble.
3. Who’s talking about it?
If you're hearing about an investment opportunity from all sorts of people, like your friends, the news, influencers, and people who don’t normally talk about investing, it’s time to be cautious.
When it seems like everyone is suddenly buying into an asset, it can be a sign that people are buying simply because they don’t want to miss out. It could indicate prices are overinflated and a crash may follow when profit-taking begins.
Understanding the signs of a bubble can help you avoid costly mistakes. However, it can sometimes be difficult to identify a bubble before it bursts.
There are times when rising prices start off from promising fundamentals, then a bubble is only formed when excitement and irrational behavior take over.
Thinking long-term and sticking to your strategy can help you filter out the noise and make decisions that align with your goals.
