How to Spot an Investment Bubble Before It Pops
Rapidly rising asset prices + increased positive media coverage is the swamp in which bubbles form
To many, investing has become synonymous with gambling.
They see it as a game, with a chance of winning big or losing it all. Of course, that’s not what investing is at all.
Real investors understand they are taking on risk, but they never put themselves in a position where they can “lose it all.” Real investors also have realistic expectations; they do not expect to get rich overnight through investing.
The difference comes down to investing vs. speculating.
Investing= buying an asset based on the underlying fundamentals like the earnings of a company.
Speculating= buying an asset based on the narrative (hype) surrounding the asset.
How bubbles are formed
Financial bubbles build up and burst all the time; think about the dot com bubble in the early 2000s, the housing crash in 2007-2008, and the crypto crash of late 2021 to early 2022.
It’s easy to look back after a bubble has burst and asset prices crash to say, “yes, that was a bubble.”
What’s more difficult—and much more useful— is to be able to say, “this asset is currently a bubble, and it’s about to burst”.
It’s such a valuable skill that if you can correctly call a bubble in advance—even once— you can dine out on that success for the rest of your life. The problem is that many people who “called” the financial crisis ahead of time also “called” about 50 other bubbles that never materialized.
A broken clock is right, twice a day.
What’s missing is a framework to identify a bubble before it bursts. To be effective, it must meet two conditions.
Be based on a rational economic theory.
Have empirical data that supports that theory.
A 2021 paper by Alex Chinco titled “The Ex Ante Likelihood Of Bubbles” puts forward a framework to explain how likely a bubble is to occur.
Here’s the economic theory that Chinco puts forward about how bubbles are formed:
bubbles should be more likely in assets where increases in past returns make excited speculators relatively more persuasive to their peers.
People who buy speculative assets usually don’t sit quietly waiting for the money to start rolling in. They try and recruit others to also buy the speculative asset—because the only way speculators make money is if they can find someone else willing to pay more than they did.
The above theory would suggest a big increase in the price of a speculative asset makes it easier to recruit new ̶m̶a̶r̶k̶s̶ investors to buy the asset too. They tap into people’s FOMO.
“This thing is going to the moon! Better jump on while you can!”
And people indeed do jump on. Which further pumps up the price, which gives the speculators more “credibility” to recruit even more people to invest.
This is how bubbles are formed.
Chinco provides empirical evidence to back up this intuitive explanation of bubbles.
He does this by examining the relationship between media coverage and daily returns of a particular industry (like tech in the late 90s).
The more a speculative asset increases in price, the more often it is written about in financial publications like The Wall Street Journal.
It also leads to a greater proportion of “positive coverage” of the asset— coverage that makes the speculative asset sounds like a great opportunity.
So-called “pre-bubble” assets saw positive media coverage after positive returns 9.2% of the time compared to 2.8% for the control group.
A disproportionately large amount of positive media coverage for a speculative asset following increases in price turned out to be an excellent predictor of future bubbles.
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When bubbles burst, wealth is destroyed
Sadly, the last people to jump on the bandwagon get hurt the most when a bubble finally bursts.
After months or even years of hearing positive news coverage about the latest hot investment trend, you finally cave and say, “okay, this thing just keeps going up, so it’s time for me to buy.”
So, you buy it at the top, and then it comes crashing down, and you lose your shirt. You thought you were investing, but in reality, you were speculating. Not knowing the difference, you decide that “investing is gambling” and become skeptical of ever investing your money again.
Therefore, bubbles destroy wealth in two ways:
Direct wealth lost by investors when the bubble bursts.
Indirect wealth lost by jaded investors who lose trust in financial markets.
The takeaway
Be skeptical about financial media or online influencers who are hyping up a particular investment. This is especially true when that asset has recently experienced big price gains.
What is the easiest way to avoid getting caught up in a bubble?
Do not engage in the day-to-day coverage of financial markets. It will only lead to the temptation to do something irrational like try and time the market or worse, invest in a bubble asset right before it pops.
The best way to describe day-to-day coverage of financial markets is to borrow a quote from the TV show The Wire; “You cannot lose if you don’t play.” Simply unplugging from financial media can do wonders for your ability to build wealth.
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This article is for informational and entertainment purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.